Firms need to put legal ethics at the heart of their business
In almost every aspect of life we all like to get a good deal. It is no different with commercial rent. Landlords and Tenants alike, both parties will be keen to maximise their profits and minimise their risks, which is why rent reviews are a particularly fundamental and heavily negotiated contract term. Essentially both parties want entirely the opposite from the other.
A Landlord will want to protect and maximise the investment value in their property. Conversely, a Tenant will want to ensure that they are paying a fair price (considering their local area) for the use of the Property during the term. In many cases the parties will agree an open market review, which is subject to numerous assumptions and disregards to determine the rent payable in that current market at the time of the rent review. The unfortunate side effect of this is it can produce a degree of uncertainty for both Landlords and Tenants. As an alternative (and notwithstanding their differing interests) both parties, in an attempt to restore some certainty to such reviews, may agree instead to link reviews to an index, as a fairer way to protect the interests of both parties at the same time. In theory, such a review should equate to a simpler, fairer and more certain result for both parties. However, in practice, it is not so straight forward.
Although much will depend on the particular terms of the deal such as the length of term and existence of break rights, coupled with the current trends in the market value of the Property, there are some key questions raised by such reviews. Principally, to what index should the rent review be linked? Historically the Retail Price Index (“RPI”) has been the preferred option. However, this index is more recently proving controversial.
Lawyers, in general, tend to stay clear of mathematical and economical based arguments or debates, reserving this for the expertise of economists and statisticians. Their skill set is accustomed to (with particular relevance to the Property Lawyer) drafting and interpreting the intentions of their client, rather than analysing algorithms or mapping changes in historic rates, trends or other mathematical calculations, to determine their relevance and suitability to a particular scenario. However, the controversy surrounding RPI and its subsequent debate is something property lawyers are indirectly affected by and therefore one which should be monitored closely.
The RPI controversy has gained traction and attention since 2013, when the Retail Price Index (“RPI”) was stripped of its “national statistic” status by the Office for National Statistics (“ONS”). In 2017 the ONS went one step further and stated that RPI “is a flawed measure of inflation with serious shortcomings and we do not recommend its use”. This is a rather damning assessment for a very widely used inflation calculator. It has also lead to the wider recognition, and a subsequent debate given the rise of the younger and more modern Consumer Prices Index (“CPI”).
RPI and CPI both aim to measure inflation by taking a basket of goods and looking at what they cost. The CPI however excludes important items such as rises in mortgage payments, rents and council tax, which the RPI does take into account.
In addition to what is included within the calculation, the crucially important difference between RPI and CPI is the method of calculation used in their respective formulae. RPI is calculated using the ‘arithmetical mean’, conversely CPI is calculated using a ‘geometric mean’, which is generally considered to be a more accurate reflection of the level of inflation that consumers are experiencing. The crux of the problem with RPI is that its arithmetic averages do not capture the behaviour of consumers who buy less of a product when it gets dearer, which the geometric formulation of the CPI does. As a result RPI generally runs at a higher level than CPI.
The level at which the index runs is critically important (in the context of rent reviews) because the higher the inflation figure, the higher the increase, and RPI has generally always given a higher inflation figure than CPI (save for notable exceptions such as in 2008 to 2009, when RPI plummeted lower than CPI in response to the financial crash). CPI therefore has the benefit of being less volatile than RPI, providing greater certainty for the parties, but it perhaps does not give a landlord the level of increases it might be hoping for or expecting over the duration of a lease term. One way to offset this of course would be to agree a cap and collar (see below).
Notwithstanding the volatility of RPI, and its controversial calculation formulae, RPI is still widely used, it remains the basis of indexation for gilts, bonds, student loan repayments and rail fare increases. Given this wide and far reaching use it seems unlikely that RPI would be abolished within the next few years.
It is worth noting however, that one major factor in favour of using RPI is the ability to avoid a risk of paying additional Stamp Duty Land Tax (SDLT) on any rental uplifts, linked to RPI. The Finance Act 2003 currently disregards future tax increases for tax purposes if they are in line with RPI. This means tenants may not be required to file an additional SDLT return or pay any additional SDLT due as a result of the increased rent, which may in part outweigh the benefit of smaller increases as would be the case with CPI, depending on the particular terms of the lease.
As a result therefore continuing with RPI maintains the ‘status quo’, which is currently accepted by the majority, so tenants are unlikely to feel hard done by if indexation in line with RPI continues to be the preferred index when conducting rent reviews. In addition it could be argued that as CPI does not capture property related changes and fluctuations, it may not be an accurate representation of property related inflation.
However, going forward financially-savvy tenants are likely to start requesting that an alternative index is used, given RPI’s downgraded status, making such an argument stronger. Lawyers who are alive to such changes and trends may add value to a client’s transaction, particularly at the heads of terms stage, where the bargaining position of the parties may be stronger. A difference of circa 1% a year between RPI and CPI can make a significant difference.
This begs the question that, given the current animosity towards RPI, is CPI the only viable alternative, or are there other indices that could be used, and that we should be aware of?
This is the younger sibling of the CPI but within its calculation it also includes owner-occupiers’ housing costs, such as council tax and changes in average residential rents. It does not however, include changes in house prices. CPIH has been recommended for use instead of CPI as it more accurately reflects the cost pressures facing UK households.
This measure of inflation has been published by the Office of National Statistics since March 2013. It uses the same basket of goods as RPI, but instead uses a geometric method of calculation similar to that of CPI.
As the geometric formulation is said to capture the real behaviour of consumers, this will usually result in a lower figure, however this index will record these changes against the existing RPI basket (which includes those relevant property related items). So although like CPI, this index would potentially have the effect of lower index rates, it would at least be recorded by reference to property related trends.
In June 2016 the UK House Price Index (HPI) was launched as an experimental statistic. House sales data from HM Land Registry, Registers of Scotland, and Land and Property Services Northern Ireland is used by the ONS to calculate the HPI. It is possible to search the house price statistics and filter the data by location, which would be useful when dealing with specific areas which are not representative of the rest of the country, such as London. In time perhaps this, or a version of it focussing on commercial properties will be seen as a more appropriate index upon which to base rent reviews?
In short there are now numerous alternatives that could be used. However, many can be forgiven for finding it difficult to see the ‘wood from the trees’ with these various indices. Moreover where does this leave lawyers and how should they approach this debate, and indexed rent reviews?
There are arguments to be had for the relevance of an index to a particular transaction. For example why should an index based on non-property related trends be used as a tracker to calculate changes in rental levels? Although these are important debates, is it relevant for a property lawyer? The answer, we suggest, is both yes and no. In part it doesn’t matter, because clients and agents will use whichever indexation rate they agree to use, and Lawyers will have to draft clauses incorporating whichever indexation rate the parties have agreed. However, from a different point of view it is of significant importance, principally for two reasons:
Firstly, Lawyers should be alive to the issues at hand in order to advise their client as to whether the chosen method for calculation really captures the intentions of the parties, and whether one maybe beneficial to the other, adding that level of commerciality to their advice. For example if the parties are merely intending to reflect and keep pace with inflation, as a tenant one would prefer CPI, whereas a Landlord RPI.
Secondly, and arguably more important is that notwithstanding which method of indexation is chosen and agreed, it is the drafting of the review clause itself that can make a difference to the level of rent that is calculated at a given review date. Whilst one might assume that by agreeing to increase the rent at a rate equivalent to the RPI increases over a period of say, five years, will always produce the same results, such a clause can be drafted in a number of different ways which can produce differing outcomes, which may or may not be beneficial to their client. It is therefore imperative that lawyers understand how such clauses are drafted, and the implications of the differences that such drafting can make. We list below a number of key points to consider when reviewing, drafting and negotiating index based rent reviews.
It is important to remember to disregard if necessary any rent free periods, amortised rent or any other rent abatements or restrictions. The definition of the ‘base rent’ or ‘annual rent’ used to calculate any rent review should expressly exclude these to avoid any confusion. This is to ensure that the correct level of rent is captured and used in the review calculation. If this is not done, it will distort the rental calculation.
This, in broad principles, is what people would expect a basic index-linked review to be. The key is to ensure that any such indexation references to base index figures and base rent are linked either to the index rate and annual rent applicable at the start of the lease, or alternatively, the most recent index rate and reviewed rent payable at the time of each subsequent review. If both ‘original’ or ‘contemporaneous’ rent and index figures are not used together, there is a chance that the review will result in an unfair outcome, for example, see below regarding double-counting.
A landlord-friendly, though dare we say, unfair, way of drafting rent review provisions is to refer back to the initial base index figure upon each review, but at each review to use the most recently revised rent each time. This has the effect of compounding the rent on each review. When acting on behalf of a tenant, this method should be resisted.
When a rent review clause is drafted to include a cap and collar, landlords can be sure that the rent will indeed increase, even if the indices fall, or stay stagnant. Equally a tenant can be sure of the maximum level of rent that will be payable after a review. Therefore, caps and collars provide both parties with certainty - the minimum and maximum rent increases are clear. With the focus moving away from RPI, which generally leads to larger increases than alternatives such as CPI and CPIH, it will be more important than ever to ensure that the agreed caps and collars are a fair representation of what increases should apply to the rent for the duration of the lease term. A tenant would not be particularly happy if the collar is at a rate that is much higher than the average increase CPI (or other chosen index) over the past few years.
Given the complexity of such reviews, it is without a doubt best practice to include worked examples in the draft documents. Although these can be time consuming, they will usually always highlight any drafting errors, and moreover provide the clients with evidence of what they have agreed, and whether it represents their intentions.
To summarise then, caution should be practiced whenever an indexed based clause is drafted, regardless of which index is used. It would not sit well with a client, be it landlord or tenant, if they had chosen a particular index, only for the drafting to skew the results beyond that which is intended. In addition, given the concerns surrounding the relevance and accuracy of certain indices it would be wise for lawyers to keep an ear to the ground and follow the debate surrounding these, in order to be well placed to highlight any potential risks or advantages to their client by using a specific index, whatever this may be.
This article was first published in Property Law Journal (May 2018) and is available at lawjournals.co.uk.
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