Our team: Madeleine Holding
Earlier this year the Chancellor of the Exchequer announced he would use the 11 March 2020 Budget Day to launch a consultation into the proposed correction to, or phasing out of, the retail price index (RPI) with a response expected before the Parliamentary summer recess.
RPI lost its national statistic status in 2013 but remains widely used, particularly in rent reviews. RPI is due to be retired in 2030 and replaced with CPIH, a consumer price index which takes into account changes in house prices, but the consultation will determine whether the government replaces it sooner. As the Treasury’s consultation should now be in full swing, we look at the different methods of rent reviews.
Some leases provide for set increases in rent at certain points during the term. These are not really review arrangements but are contractual terms agreed and set out at the start of the term. These arrangements give both parties certainty of the rent payable throughout the term but it is a gamble as to whether or not the arrangement will pay off later on. For landlords there is a potential for yields to rise ahead of the market in bad conditions but also potential to fall behind where the rental market is prospering.
The most common type of review seeks to match the rent to the value of the premises on the open market; the parties determine what a willing tenant might reasonably be expected to pay in the open market at the review date. It is usually calculated with reference to the terms of the actual lease but certain features are assumed to exist and others are disregarded. The operation of open market rent reviews can be complicated, costly and time-consuming, usually involving a third-party surveyor considering the submissions of each party. Some landlords may prefer certainty and rental income which can be more quickly determined.
The most common type of open market rent reviews are known as “upwards-only”. As an open market rent review could result in a reduction in the amount payable, most leases provide that the reviewed rent cannot be below a certain level; for example, the rent payable immediately before the review date. Upwards-downwards rent reviews are very rare but might be agreed by landlords in poor market conditions in a bid to ensure it has some income from the property.
RPI measures the average change from month to month in the prices of goods and services purchased by UK households. It is considered to have a flaw in its calculations which causes it to be around 1% higher than most other consumer price indexes. RPI rent therefore increases in-line with these changes. Although RPI rent reviews do not give either party much certainty, the calculation is at least straightforward.
The office for national statistics have made it clear that they do not think RPI is a good measure of inflation and discourage its use but its overestimation is clearly favourable to landlords and it therefore remains widely used. If the result of the Government’s consultation is to align RPI with CPIH, landlords may see lower increases in the years to come. The Treasury has previously ruled out any change before 2025 but so far the consultation has given no clarity on when the change could happen (between 2025 and 2030) leaving the market uncertain for now.
The benefits of RPI rent reviews are not one sided. Any increases in rent during the first five years of the term are taken into account when calculating SDLT, except where the adjustments are in line with RPI; these adjustments are ignored which can be attractive to tenants. The exception currently only applies to RPI, not other consumer price indexes. It’s not yet clear whether the exception could be extended but if RPI is phased out, we could see a significant reduction in the number of index-linked leases.
Rent reviews can be an important income source for landlords of commercial property and can ensure that the rent keeps pace with changing market conditions. Choosing the right method for rent review must therefore be considered carefully when negotiating heads of terms with tenants. Landlords entering into new leases which will continue past 2025 should consider whether RPI will continue to be beneficial or whether a different rent review method may deliver better results.