The Retail Price Index (RPI) remains a “flawed” measure of inflation. So says the UK’s Office for National Statistics. However, it also says that this measure of inflation still remains prevalent in commercial contracts. RPI has in actual fact not been an official UK statistic for several years after the Office for National Statistics decided that the calculation did not meet international standards. Rather, the Office for National Statistics has begun to use an alternative measure of inflation in the UK economy with the emergence of CPIH – a measure of consumer prices which includes housing costs. RPI and CPI rates have diverged sharply of late with the retail index around 70 basis points higher than the headline inflation measure; so, where do index-linked rents now feature within the commercial real estate market?
RPI v CPI
Index-linked rents in commercial real estate are still prevalent and commonly used as an alternative to open market rent review; the benefit being that it can be calculated almost immediately disposing of the often protracted and lengthy comparable test. The efficiency associated with a formula based calculation means that the rent can be reviewed more often – annually or retaining the traditional three or five yearly review.
RPI has generally been superseded by the Consumer Prices Index and that formula tends to be in the benchmark used in commercial leases these days. A properly drafted lease will however anticipate the possibility that the index could be replaced or rebased during the term of the lease. Unfortunately, however, when CPI is used the Stamp Duty Land Tax (SDLT) cannot be ignored as it can with RPI. One would assume that HMRC will amend that anomaly.
The rent tends to increase in line with increases in CPI (almost all rent review provisions are on an upward only basis and so do not tend to reduce the rent in the event of negative inflation). Generally speaking, as we have seen over the years, an index-linked rent has resulted in minimal increases. Landlords, inevitably, want to ensure that as a minimum the lease does not allow the rent to decrease in a deflation scenario with “collar and cap” arrangements being put in place to ensure a guaranteed minimum rental growth.
Collar and Cap
This is a clever mechanism to ensure a maximum and minimum increase on rent on each rent review date. For example, a collar of 3% and a cap of 6% means that the rent will always increase between 3% and 6% per annum on each review even if the CPI has increased by more or less than those figures. Collar and cap needs to be compounded, however, if the rent is not being reviewed annually.
Indexing rent is an efficient and cost effective mechanism to review rent. It does, however, assume that the open market rent will follow inflation. That will not always be the case.
Parameters, as we all know, are always changing, so it is important to ensure that rent review mechanisms are commercially sound.
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