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Earlier this year, the Office for National Statistics published a statement saying that the Retail Price Index (RPI) "is a flawed measure of inflation with serious shortcomings and we do not recommend its use”.
Surprisingly, this is old news. RPI was stripped of its “national statistic” status by the ONS in 2013 when they decided that the outdated arithmetic formula used in its calculation did not comply with international standards.
The ONS' preferred measure of inflation is the more modern Consumer Prices Index (CPI), supported by the recent emergence of the new CPIH Index which was accredited with the “national statistic” status earlier this year. The CPIH is essentially the CPI adjusted to reflect changes in Housing costs.
The simple answer is that it is compelled to do so by legislation, since it is still widely used. Some government spending remains linked to RPI whilst student loan repayments and annual rail fare rises are also linked to the measure.
The annual rate of CPI inflation in July 2017 was 2.6 per cent whereas RPI came in at 3.6 per cent, a marked increase on the RPI figure of 2 per cent for September 2016. Many of you may feel that pain when your 3.6% annual train fare increase bites on 1 January 2018.
In the commercial real estate arena, businesses face a sharp rise in business rates as the Uniform Business Rate multiplier, which determines the level of business rates payable, is uprated annually in line with the RPI. According to the business focused newspaper, City A.M., the retail sector alone is likely to face a £301.69m increase next year which is another blow since there was already a significant hike in business rates in April this year following the latest revaluation.
The government has committed to switching business rates indexation from RPI to CPI but implementation is not planned until 2020.
Index-linked rental increases are widely used in commercial leases as an alternative to open market rent reviews. They are considered to be more efficient as they can be immediately calculated and avoid the lengthy rent review proceedings commonplace in an open market rent review. Index linked reviews are also more flexible, allowing for annual reviews or other review periods less than the normal 5 yearly reviews seen for open market provisions.
Predominantly RPI remains the chosen benchmark for index-linked rents, mainly as it gives landlords a higher uplift in rent.
There is a slight silver lining for a tenant in that any increase in rent which is “in line with” RPI can be ignored for Stamp Duty Land Tax purposes.
The general rule is that any increases in rent during the first five years of a lease have to be taken into account when calculating the amount of SDLT payable. Where the actual level of increase is not known when the lease is completed, an estimate should be made and once the actual increases have been ascertained, further SDLT returns should be submitted. One exception to this general rule is for increases in line with RPI. Particular care should be taken when seeking to benefit from this exception as there are certain caveats. For example, the wording of the guidance is ambiguous as to whether or not the exception applies if the increase is subject to a minimum fixed percentage increase, regardless of whether or not the RPI increase actually reaches that minimum threshold.
It's a small concession but one that does not apply to increases in line with CPI (or indeed any other index).
Increases in line with CPI are possible, although many landlords may not agree to this as it gives them a lower rental uplift. It is common to see leases include both index-linked rent reviews and open market rent reviews, with the final uplift in rent being the higher of the two amounts. This obviously negates the benefits of the quicker determination of the rent review as both paths need to be followed to determine which produces the greater rental amount.
Another possibility is for fixed rental increases to be agreed in place of rent reviews. This gives certainty for both parties throughout the term of the lease but does not take into consideration future market conditions.
The ONS published a new inflation index known as RPIJ in 2013 which is based on a geometric formulation known as Jevons. This index runs alongside the RPI but is rarely, if ever, seen in commercial rent review clauses. The RPIJ is meant to give a truer reduced level of inflation so, as with the CPI, a landlord may be reluctant to agree to it.
Entering into a lease can be risky if you have not carefully considered how the amount of rent can increase over the course of a lease term. Make sure you take legal advice before agreeing to any form of index-linked rental increases in a lease or, ideally before heads of terms are agreed. We would always advise that a worked example is included in rent review provisions to ensure that all parties are clear as to how the formula for the increase is applied. We would also strongly suggest taking advice from a surveyor to determine whether or not the principles of any proposed rent review mechanism are commercially sound.
If you want to speak to somebody about any of the issues raised in this blog, please contact a member of our Real Estate team.
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