Index linking rent reviews: deceptively simple

As the old proverb says: “There’s many a slip ’twixt the cup and the lip.” Rarely is this more true than with index-linked rent reviews, which have become increasingly popular in recent years. By linking rent to inflation rather than to market rents, the rent review process is reduced to a simple mathematical formula that can be performed with a few touches of the buttons on a calculator. With no need for market analysis or comparable evidence, index-linked rent reviews should be quick and straightforward, affording little room for disagreement or argument. So, what could possibly go wrong? The index In theory, there is no right or wrong answer to the question of which index to link the rent to. So long as the parties are agreed and the index is readily available, any appropriate index can be adopted. A well-drafted clause will allow an alternative index to be substituted should the chosen index cease to be published during the term. The Retail Prices Index (RPI) remains the most commonly encountered index in practice, although its dominance is increasingly being challenged by the Consumer Prices Index (CPI). Even though RPI has lost its status as a national statistic, it remains popular among landlords because it rises faster than CPI. Using RPI also offers a Stamp Duty Land Tax saving for tenants, since it is the only index that can be ignored when calculating the net present value of a lease. I’ve even heard of Gross Domestic Product (GDP) being used, although I would question whether that is an appropriate index to choose for this purpose. The base figure Since the whole purpose of an index-linked rent review is to reflect movement in the index, it is self-evident that the formula should track movement in the index over the review period. Most leases calculate the increase in the index since the last review date (or the start of the lease on the first review) and apply that increase to the passing rent, but it is easy to get this wrong. It is perfectly possible to use the classic formula but still produce an absurd result, if inappropriate or imprecise definitions are used. For example, if Base Figure is defined so that it is always the index figure at the start of the lease (rather than the index figure at the last review), then on each review the increase in the index since term commencement is applied to a passing rent that already reflects inflationary increases from previous review periods. The landlord will receive the benefit of the same increases in inflation multiple times, on a compound basis. The table below illustrates how quickly this can escalate, based on a hypothetical 25-year term with annual increases, a modest starting rent of £25,000 per annum and a modest annual increase in inflation reflecting the government’s 2% target. The standard definition of Base Figure also needs to be considered where the transaction is unusual. For example, a reversionary lease whose term commences several years after the lease is granted, perhaps commencing upon the expiry of an existing lease. Elmfield Road Ltd v Trillium (Prime) Property GP Ltd [2016] EWHC 3122 (Ch); [2016] PLSCS 350 concerned such a reversionary lease. An index-linked rent review in the fifth year of the term was based on the increase in RPI since the lease was granted, which was nearly five years before the term commencement date. This allowed the landlord to apply nearly 10 years’ inflationary increase to a rent that had already been reviewed five years earlier on the term commencement date. The High Court upheld this significant windfall to the landlord and the tenant’s appeal is currently scheduled to be heard in May 2018. The base rent Having calculated the increase in the appropriate index over the correct period, that increase will usually be applied to the passing rent payable immediately before the review date. Sometimes, however, the formula applies the increase to the initial rent payable under the lease. This is more common in leases where there is only one rent review during the term. The trap here occurs where the initial rent used by the rent review formula is a concessionary rent rather than the full market rent. I have seen one lease where the initial rent for rent review purposes was 50% of the market rent, to reflect a six-month rent-free period spread over the first year. And a rent review surveyor recently told me about a lease he had encountered where the initial rent used by the formula was nil. Cap and collar Index-linked rent reviews frequently incorporate a “cap and collar” mechanism. The cap protects the tenant from spikes in inflation by limiting the maximum increase on review, usually to somewhere between 3% and 5%. The collar, on the other hand, guarantees the landlord some rental growth in times of low inflation. The collar is often set at 1%, or sometimes 0% to protect the landlord from the risk of the rent decreasing in a deflation scenario. If the rent is reviewed annually, as is frequently the case with index-linked rents, this is relatively straightforward. However, many index-linked rent reviews retain the traditional five-yearly review pattern, in which case the cap and collar need to be carefully considered. One of the most common mistakes with non-annual reviews is to apply the cap and collar over the whole review period rather than annually. Assuming five-yearly reviews with a 4% cap and a 1% collar, the landlord does not want to be limited to a 4% increase over five years. The cap should of course be calculated as 4% per annum. With annual compounding, the maximum increase over five years is 21.67% and the minimum increase is 5.1%. An alternative to the compounded cap and collar for non-annual reviews is for the lease to require a notional rent review for each year of the term, but with the rent only increased in accordance with every fifth notional review calculation. Get the maths right Even where the lease provisions are perfect, it is still possible to achieve the wrong result by making simple arithmetical errors when applying the rent review formula. On one lease I encountered recently, a previous landlord had made an error when calculating the indexed rent on the first review. That incorrect rent figure was then used as the base rent on the next subsequent review, so that the initial error was perpetuated and magnified over time. It is therefore important as landlord to check the calculation, and as tenant to double-check that any calculation received from the landlord is correct. Key to success If both parties accept that the rent payable under the lease will reflect the value of money rather than market rents (and may also cease to follow the value of money if interfered with by the use of caps and collars), then index-linked rent reviews can provide a quick, easy and cheap means of reviewing the rent payable under a lease. As we have seen, there are several traps to be aware of, both in terms of structuring the lease and implementing the rent review formula. The best advice I can offer is to produce a worked example before the lease is agreed. The worked example may or may not be incorporated into the lease, but either way it allows the parties and their professional advisers to verify that the clause works as intended and to identify any errors and potential issues that need to be addressed. Top tips for landlords and tenants ■ Carefully consider which index to link rent to ■ Check and double check the arithmetic ■ Calculate a hypothetical example before the lease is agreed The formula R=AxC/B Where: R is the revised Main Rent; A is the Main Rent reserved immediately before the relevant review date; C is the Current Figure; and B is the Base Figure Source: Model Commercial Lease Bill Chandler is a professional support lawyer at Hill Dickinson LLP