News | December 21, 2022

Inflating rents?

Rents linked to inflation, rather than to open market levels, have been a feature of the logistics sector for a number of years now. If other sectors are considering these, what should they be aware of?

First, pick your index. The long-established retail prices index (RPI) often shows a higher rate of inflation than the modern consumer prices index (CPI). This is partly because they measure different things: CPI is internationally comparable and so doesn’t include mortgage costs. However, there is a version of the CPI which does reflect the quirks of the UK housing market – CPIH – which can be used rather than the CPI main all items index. The differences are also due to the age of the two indices. RPI was based at 100 in 1987 while CPI was based at 100 in 2015. When your index is at 100 and inflation increases by 1%, the index rises to 101. But when your index has risen to 200 and inflation increases by 1%, the index rises to 202. As the index creeps up, it tends to overstate the impact of small increases, highly relevant when RPI as at August 2022 is 343.2 and CPI is 123.1. The other difference is the formula – RPI uses arithmetic mean but CPI uses geometric mean. The Financial Times notes that since January 2015 the average reduction in inflation due to this formula effect is 0.81 percentage points.

Second, check whether your chosen index will survive as long as your lease. CPI has been the official government measure of inflation since 2011; two years after that the Office for National Statistics declared that RPI was no longer an official statistic. What will happen to your index linked rent review if the ONS stops publishing the RPI? Most standard clauses allow for a new index to be substituted if the original one is no longer published. But is it really the case that the CPI would be the right substitute for the RPI for a lease dated after the CPI became the official measure of inflation or dated after 2013 – when RPI stopped being an official statistic?

Third, think about how much the rent will vary with inflation. It’s not unusual to see a cap on the amount of any inflation -linked increase, which is the maximum the rent will rise. These are accompanied by a collar, or a guaranteed minimum increase. Collars also protect landlords from falls in rent if inflation becomes negative (also known as deflation). The combined effect is to smooth rent changes over the duration of a lease.

Inflation-linked rent reviews could happen every year. It’s not unusual to see them compounded – the rent nominally changes each year but the increase only takes effect every five years. The compounding is market standard but be sure to get the formula correct. If the numerator and denominator are mismatched, tenants might find themselves paying far more than they’d intended. Run a worked example to make sure compounding works as you intend, going to the end of the term. 

In Arnold v Britten [2015] UKSC 36, the service charge increase was 10% a year. The compounded effect of this meant that the annual cost rose to become more than the mobile homes paying the service charge were worth.

Index linked rents can avoid long and contested rent reviews, but traps for the unwary remain.