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What is today's blog about?
In this week’s blog, Ola Alade MSc MRICS, Chartered Surveyor and Asset Manager at LCP Group looks at index linked rent reviews and inflation.
Ola is also an experienced RICS APC assessor and has tested many of our successful candidates out in e-mock interviews!
This week’s blog is essential reading for all Commercial Real Estate candidates pursuing the Landlord & Tenant competency. The blog will also be relevant to property managers, asset managers and investment managers, amongst other surveying roles.
What is an index linked rent review?
An index linked rent review is simply a rent review clause that is linked to an index that tracks inflation, notably RPI and CPI.
They are generally still not as popular in leases as open market rent reviews.
A reason for this could be down to RPI being linked to inflation and the UK not seeing a lot of high inflation periods until recent times. Another factor could be that inflation is a general metric that affects all goods and services. It, therefore, does not account for strengths & weaknesses, location and supply and demand forces at the property level.
For example, let’s say there that there is a brand new mixed-use property in a recently regenerated area, with an affluent consumer population. The inflation rate could have increased by 3% for the rent review period, whilst in the actual market, demand from occupiers could be seeing regular offers of 50% over asking prices. In this situation, a property on an indexed linked lease will perform significantly worse than one with an open market linked lease.
Nevertheless, indexed linked rent reviews are still a valuable tool in an asset manager’s tool kit, as they protect the property owner's income (rent) from the effects of inflation and require less lease management.
What are RPI, CPI and CPIH?
All of these indices are derived from prices of a representative basket of services and retail goods and the fluctuation of these prices shows the rate of inflation across time.
RPI typically tracks higher than CPI because the methodology for CPI removes housing costs, which are quite significant in the UK.
Both are tracked and published by the ONS mid-month. Currently, inflation is running high with CPIH at 8.6% (released 14 September 2022), compared to the Bank of England target of 2%. There are a variety of reasons for this trend – you can read more on the Bank of England website.
A robust understanding of basic economics is, in fact, essential for all RICS APC and AssocRICS candidates.
The government has announced plans to phase out RPI, moving towards CPIH (CPI including housing), which is a more accurate tracker of inflation. We will stick with RPI for this article, but the principles remain the same for CPI.
How do surveyors use these indices?
The RPI numbers for the previous month are posted monthly by ONS (i.e., January numbers are posted in February). Surveyors use these numbers to calculate the new rent for leases that have RPI linked rent reviews.
Types of RPI rent reviews
Simple RPI linked rent review – this simply spells out that the new rent will reflect the inflation from one period (last review date) to another (current review date). This difference between the two RPI numbers will be presented as a % and applied to the passing rent to calculate the new rent.
RPI linked + fixed % (e.g., 1%) - this tends to solve the problem of profit on the investment (reducing the payback period) making the asset a more secure investment. This can be represented by a lower yield, meaning a higher capital value of the asset.
RPI with caps and collars - these are indexed linked reviews with a limiter or guarantee on the amount of increase that can be calculated. An example of a cap is if RPI has increased by 10% in the review period and there is a cap of 5% written into the lease; the rent review will be settled at a 5% uplift on the new rent. A collar is a minimum % that the rent will be increased by. An example is if the RPI has increased by 1.6% in the review period and the collar is 5%, then the rent review will be settled at 5%.
In the case of the cap (RPI increased by 10% but lease caps to 5%), the property owner will suffer losses on a real return of 5% annually for the rent review period. Whilst this does not seem like a lot over a review period, i.e., 1, 3 or 5 years, this can affect the performance of the investment when you consider the cumulative losses across the term.
Calculation and miscalculation
Typically, simple RPI leases feature calculations such as:
Review dates can typically be 1, 3 or 5 years apart. This formula reflects the cumulative inflation rate for the given rent review period.
This simple calculation in the lease can result in more onerous interpretations if incorrectly drafted.
An example of a case I have come across...
A scenario where the "C" in the formula was tied to the start date of the lease with no supporting text. The supporting text was supposed to explain the treatment of "C" at the next rent review. It should normally say something like i.e.,
"at subsequent rent reviews "C" will represent the RPI number at the previous rent review date".
In these cases, without the text, the % now represents the cumulative inflation rate from the start date of the lease to the current rent review date. This is error double counts the inflation rate for an increasing amount of years (start date to rent review date) at every rent review until lease expiry.
Worked example for illustration
If the RPI figure for start date of the lease was 174.40 and the current RPI number for the current rent review is 304, this would show a cumulative inflation rate of 74%, which is multiplied by the current rent to give the new rent. It is not hard to see that a 74%+ increase at each rent review can cause huge problems.
There have been situations where this error can lead to calculations of new rent in the millions and billions, especially when you are dealing with a high passing rent.
Is prevention better than cure?
A quick preventative measure for this is either introducing the supporting text with instructions for subsequent rent review or tying the formula to the "initial rent" of the lease, instead of the "passing rent".
In lease transactions, just a small section of wording can have such huge economic consequences.
These formulas are usually because of a mistake in the lease drafting. It highlights why it is crucial for both property owner and tenant to "game out" each element of the lease including rent review mechanics to ensure everyone understands the implications of the lease terms that are being agreed. The RICS also recommend that property professionals should be instructed alongside a capable solicitor for advice at lease renewal (in the Professional Statement Code for Leasing Business Premises).
Now Inflation?
Now that annual inflation is currently at 8.6%, depending on the property, the likelihood of situations where RPI rent reviews achieve more rent than the open market alternative will be much higher.
In these cases, property owners will experience losses in real returns which can be disastrous for the performance of the investment, when compared to other investment vehicles. It is unlikely that this unprecedented level of inflation would be modelled into investment decisions, so this is something asset managers will need to actively grapple with.
Summary
In summary, RPI leases typically track a lot slower than their open market contemporary because the open market is geared to market deals which factor in demand. An RPI linked rent review is a hedge against inflation ensuring real returns.
RPI linked rent reviews are also useful in situation where RPI rises faster, in large assets in obscure locations, for tenanted but undesirable plots of land and in situations where there is not a lot of demand or transactions in the market for the type of asset in question.
In the absence of transactions, justifying rental increases can be difficult. In these situations, RPI linked rent reviews ensures the returns are not cannibalised by inflation and when coupled with +(insert number)% factor, it can drive an inflation adjusted return.
The future
One reason that RPI rent reviews are not popular in the UK is due to the historic low levels of inflation we have had and traditionally open market rents have outstripped inflation, creating better returns for the property owner.
With high inflation now being a new reality, perhaps we need to look more closely before discounting RPI rent review clauses vs open market clauses? Will we start seeing more "higher of RPI and open market leases", especially in alternative asset types?
It remains to be seen…
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N.b. Nothing in this article constitutes legal, professional or financial advice.