In a property context, service charges help spread the cost of looking after any communal or shared areas of a building between those who use and benefit from those areas. A block of offices or apartments would typically have a shared staircase and lift for everyone in the building; there would be shared walls and structural elements, and it may also have an external carpark and garden area.
All of these amenities must be maintained and serviced by the building owner or the management company, and although at first glance it may seem that the provision of these services is worth the tenants paying more rent for, the reality is that a completely separate service charge exists to cover these costs. This charge can vary significantly from year to year, depending on what needs to be done in any given year.
Compare It to a Birthday Meal
To use a metaphor from everyday use; let’s say a group of friends take a pal out for a birthday meal at their favourite restaurant. Fairly standard practice would dictate that everyone pays for their own food and drink, however, the group may agree to chip in and pay for the birthday boy or girl’s meal – this would be then treated as a ‘communal’ cost to be divided up amongst the group. This process may even be extended to include any extras that were purchased in advance of the meal, such as balloons and decorations for the restaurant table, the card, the gift, and the cake.
Someone has to organise and ultimately pay all of these costs, but they can then be added together and divided amongst the group, to work out each person’s contribution. Before you know it, you have a form of ‘service charge’ in operation – not in the context of a general tip to the restaurant staff that might immediately spring to mind, but as a way of sharing out communal costs to a group of interested people.
The Importance of Service Charges in Relation to Properties
In the property market, service charges are often misunderstood. Landlords and investors may not realise the potential for these charges to reduce their own costs, or they may inherit poorly-managed charges and contracts from a previous owner. Occupiers and tenants sometimes don’t even realise that these costs exist, and, more often than not, don’t know what they can or cannot do about them. And those involved in drafting service contracts and managing the money, whether that be a management company or an owner, may not always realise the obligations that are incumbent upon them once they collect service charges.
In many cases, the impact of service charges is under-estimated at the beginning of a contract, but over-estimated later on. So right at the beginning of a deal, before a lease is even signed or a sale is completed, is the time to shape them the way you want them – to find out what exactly you need and are obligated to have; to get the right costs and mechanisms agreed and in place, and to know the circumstances in which each contractor or vendor can increase their price.
Poorly devised or badly managed contracts can take years to eventually cause problems. You have a potential time bomb on your hands, and when the time comes (and it will) that significant work needs to be carried out on the building, that is when they will become apparent. If you’re in the midst of a sale or a letting at this stage, then you really need to dig deeper, interrogate the accounts, and get a true picture of the situation right away.
The Two ‘L’s - Leases and Law
Service charges are generally determined by what can be known as the two “big L’s”. Firstly, any Lease documentation will explain the relevant charges. Service charges technically only exist through leases and variations of leases, although you will see similarly-principled maintenance charges in freehold title contracts, therefore what you add to (or leave out of) the lease will determine what you have to pay or recharge.
There are often many different sections, and it is important to read and understand the entire document. It is just as important to understand what services and repairs the landlord is obliged to carry out, and how these will be charged and accounted for, as it is to know the cost of the charge.
Secondly, there is the Law of the land, and any legislation in place outlining how service charges should operate. This is particularly relevant and useful when it comes to long-leasehold residential property, as it offers protection for people regarding their homes and money.
The general guideline is to be ‘reasonable’; so a landlord should only obtain sensible and best-value services (not necessarily the cheapest), and likewise, the tenant should then pay their fair share. There will always be situations where the legislation is not clear-cut, particularly with commercial property, but there is often an implied basis of reasonableness, which, in the case of a serious dispute, would be resolved by a court or a tribunal. Any third parties, such as solicitors or managing agents involved in the matter may have their own regulations or guidelines to adhere to.
The ABC of Service Charge Accounts
When you boil it down to the practicalities of dealing with the actual service charge invoices sent to tenants, and the cost of maintaining the communal areas incurred by landlords, the 3-pronged principle of ABC (‘A’ for accounts, ‘B’ for budget, and ‘C’ for cash) is a useful way to look at things. Although we are all very familiar with the “ABC” sequence; for the purpose of looking at this issue, it’s best to look at them in a different order.
B for Budget
The budget is a forecast of what the landlord thinks everyone needs to pay over a period, typically a year. So going back to our birthday meal scenario from earlier, you might have a budget of £50 to pay in total for the birthday; this would be broken down into different types of expenditure costs, such as £20 for their meal, £10 for drinks, £10 for decorations, £5 for a special cocktail drink, and £5 towards the birthday cake. If you have 10 people chipping in for the eleventh (birthday) person, then it would apportion out to £5 for each of the ten people.
C for Cash
Cash is obviously a critical component of the scenario. The money collected from service charges should be kept completely separate from all other money, including rent, and held aside to pay for the upkeep of and repairs to the property. It should accumulate so that when you need to do major work, you have money in the bank to pay for it.
Going back to the birthday meal example, in an ideal world you might have a piggy bank that everyone pays their contribution to before setting out for the restaurant. This eliminates the need for an individual to have to pay for things in advance themselves. The money required has been collected before the decorations and cake etc. have been bought, and long before anyone arrives at the restaurant.
A for Accounts
The accounts show all of the money that has come in, and all of the money that has gone out. This is done periodically – often annually, and after the period of time in question, all of the costs are totted up and matched against what was charged to everyone. If you spent more than you received, then you may need to raise an extra balancing charge to tenants. Likewise, if you didn’t spend it all then a credit should be given back. So at the birthday meal, the person organising the piggy bank can then go through all the receipts, and if everything actually adds up £60, they will need another £1 from all 10 contributors to even things up.
With property it’s the same principle, with a final reconciliation of the accounts being needed and then a certificate being issued. You may even need an external accountant to verify this, particularly with a residential property, and to produce additional financial information such as balance sheets. You may also be able to find ways to separately allocate cash to a reserve fund, which would be held aside for a rainy day to pay for a major refurbishment down the line.
Getting to the Bottom of Service Charges
And there we have it, the basic principles of what a property service charge is with, how they are shaped through both leases and legislation, and the ABC principles of how these charges and accounts should operate.
We have a training video here and below which considers these basic principles of property service charges into 5 simple stages, with full transcript and slides available for immediate use.
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