Every year, owning a leasehold flat entails paying an expense known as service charges, and this will persist for the duration of your ownership of the property. From the perspective of a freeholder or residents management company, you will be determining the service charges, collecting them, and distributing them down to the last cent. Regardless of the case, gaining an understanding of the workings of service charges is imperative.
In the case of disputes regarding leaseholders and landlords, service charges seem to take precedence over everything else in the realm of residential leasing. Most disputes have to do with a lack of clarity regarding the purposes of the charges and the reasonableness of the amounts being charged.
We will take a look at the what, how and why of service charges as well as the responsibilities of each party involved.
What Are Service Charges?
Service charges are expenses charged to leaseholders for maintaining and managing a residential building. The money funds the maintenance of the shared parts and collective services provided to the tenants.
The managing agents and freeholders do not impose service charges as a way to create profit. The charges collected belong to leaseholders, because service charges funds are required to be spent on the operational costs of the building. These funds are to be collected, spent, and managed as described in the lease agreements and applicable governing laws.
The amount each leaseholder contributes is typically calculated as a percentage of the total costs and is detailed in the lease. In a building where all flats are the same size, the split might be equal. In buildings with a mix of flat sizes, larger properties typically pay a larger share.
What is typically included in the service charges?
While the specifics can change from building to building, the majority of service charges cover a combination of a few listed items.
Building insurance is included almost always. This includes coverage for the structure of the building and the common parts from fire, flood, subsidence and other similar risks. Note that this is the building only, and not the contents of individual flats.
Maintenance and Repairs cover the day to day maintenance of the common areas and the fabric of the building — this includes cleaning, gardening, lighting, minor repairs and general wear and tear. Larger works such as roof replacements, brickwork repointing, and lift refurbishing may be separately funded through the sinking fund, or via a one-off demand.
Management fees is the expense of the managing agent's services, if one is appointed. This is a legitimate service charge item, but the fee must be stated in a clear manner and proportionately to the amount of work done.
Utilities for the communal areas — electricity for the hallway lights, water for the shared gardens, communal heating in some buildings, etc — is included in the charges.
Health and safety compliance consists of several components. These include fire safety, lift maintenance, electrical testing of shared systems, and asbestos surveys when necessary. Such elements of compliance are not optional and are legal obligations for most residential buildings.
What Is a Sinking Fund?
A sinking fund, also referred to as a reserve fund, is a financial pool created by leaseholders to fund large, typically one-in-a-lifetime, renovations. Instead of charging residents a large one-time fee when a roof is due for replacement or a building exterior needs to be repainted, an effective sinking fund allows a building to charge residents progressively over time and have the necessary funds when the work is due.
Sinking funds are not a legal requirement and, in fact, many buildings operate without one or fail to adequately fund one when required. From a leaseholder's standpoint, a sinking fund reflects good management. From a freeholder or RMC point of view, having an adequate sinking fund cushions the management and reputational burdens of having to issue large, periodic, and unanticipated charges to residents.
When purchasing a leasehold flat, determining the status of a building's sinking fund and known future major works is crucial. An old roof and an empty reserve fund is an expensive problem, and one worth knowing about during due diligence.
How are service charges set?
Service charges are based on actual cost required to run and maintain the building. Each year, the freeholder or managing agent draws up a budget that estimates the building's operational expenses. Leaseholders make advance payments against that budget. At the end of the year, the budget versus actual results are reconciled. If the actual costs exceeded the estimates, leaseholders pay the difference. If the costs were less, the surplus can be carried forward for the following year or refunded.
The budget process is important. If a managing agent prepares comprehensive and detailed instructions and budgets, and provides clear rationales to justify major increases, they are doing a good job. Budget requests with a lack of specificity or rationale are cause for concern.
What leaseholders should know
Service charges should be reasonable. Beyond driving the point home, there is a legal standard that can be referenced for this practice. It is unreasonable for leaseholders to simply pay the charges they are given.
Reasonable requests include an explanation for high demands. It is more than a formal process to arrive at an explanation that satisfies the demands. Understanding the basics of what and why you are being charged is the foundational layer that is required for the subsequent formal processes to be effective.
Your managing agent should be made aware of the fact that a service charge demand should include a summary of relevant costs and a summary of your rights.
What RMCs and Freeholders Should Know
There are important obligations when setting and collecting service charges. The service charge funds must be placed in a specific trust account that is separate from all other funds. Annual accounts must be prepared and presented to leaseholders. If major works are contemplated that exceed a specific threshold, there are requirements to consult before any contracts are awarded.
All of these details are important, and not just to tick a box on a compliance checklist. Well structured and transparent service charges enable management teams and leaseholders to enjoy a positive working relationship, and in some cases, even a partnership.
A leaseholder that understands what they are paying for and appreciates that the funds are being spent appropriately is far less likely to become a problem.