Index-linked rent reviews

Index-linked rent reviews have become increasingly popular in recent years. By linking rent to inflation rather than to market rents, the rent review is reduced to a simple mathematical formula.  But is it really that simple?

The Index – which one?

The Retail Prices Index (RPI) is the most commonly used index in rent reviews but some will refer to the Consumer Prices Index (CPI). RPI is popular with landlords because it generally runs at a higher level than CPI.

Both RPI and CPI reflect the monthly change in the cost of a “basket” of goods and services but they differ, sometimes by a percentage point, as they track the costs of different items.

One bit of good news for tenants is that using RPI offers a stamp duty land tax saving as it is the only index that can be ignored when calculating the value of a lease for SDLT purposes.

The common way to offset the higher rate of inflation generally produced by using RPI is to agree a cap and collar.

Cap and collar

As the name suggests, a cap is the maximum increase or an upper limit.  So if the formula in the lease produces a rent above the cap, the revised rent will be limited to the level of the cap.

A collar is a minimum increase.  So if the formula produces a rent that is lower than the collar, the revised rent will be bumped up to the level of the collar.

The formula – check it!

With no need for comparable evidence or market analysis, index-linked reviews should be quick and straightforward, leaving little room for argument. But it is vital that you check the formula for a number of the reviews (not just the first one) to be sure that it doesn’t produce unintended consequences.

For an annual straight line increase in accordance with RPI, there are generally two ways of drafting the formula:

• a % change in the Index is applied to the initial rent – so each year the formula takes the initial rent and applies the % change in the Index since term commencement
• a % change in the Index is applied to the current rent – so each year the formula takes the current rent and applies the % change in the Index over the previous year.

The danger is to get these two muddled up, which produces a ratcheting effect with an inflated rent and a windfall for the landlord.

Only last year a case[1] was heard in the Court of Appeal in which, as a consequence of the way that the RPI formula was expressed, the rent was over-inflated by over £300,000 a year.

Straight line or compound?

Many landlords require a ‘compound’ RPI rent review on a five-yearly basis.  This means that the rent is reviewed to the figure that would be achieved had the rent been reviewed annually on an indexed basis throughout that five year period and applying a cap and collar to the calculation for each year.

The reference to compound essentially means that a cap and collar are applied to the notional rent increases each year even though the actual rent will be increased every five years.

Key take-away point

Without doubt the key message is to triple-check the formula with example rental figures – to be sure that it doesn’t produce an unintended consequence on future rent reviews that might well be too late to correct.

[1] Trillium (Prime) Property GP Limited v Elmfield Road Limited [2018]