Tue 02 Jun 2020

Review of Retail Price Index - what does the future hold?

Earlier this year, the Chancellor announced a consultation on reform to the methodology of calculation of the Retail Prices Index (RPI), which could have a major impact on RPI-linked rent reviews. 

Whilst at one time open market reviews dominated the letting scene, RPI is now used widely for rent reviews in leases, as well as across the economy as a measure of inflation.

RPI is not the only index in use, but is still regularly used, and has been for many years now.

It brings the benefit of certainty, a sense of fairness in its reflection of indexation and has the benefit of avoiding lengthy disputes between the parties.

Commonly now, index based rent review provisions in leases contain an element of future proofing, by containing caps and collars. These provide minimum and maximum annual increases.

In 2015, the Johnson Review (an independent review of the UK Consumer Price Statistics) concluded that RPI should be considered as a legacy index and be phased out over the long term.

Questions over RPI have resurfaced again. The methods used to produce RPI no longer meet international statistical standards and the UK Statistics Authority considers that it has become a poor measure of inflation. Their proposal is to amend the methods and data sources for calculating RPI, rather than abolishing it.

Their inkling is towards the use of the same methods and data sources for RPI as are currently used for the Consumer Prices Index including owner occupiers’ housing costs (CPIH), which is the Office for National Statistics’ lead measure of inflation.

Will this benefit landlords or tenants?

The measured rate of RPI annual inflation has, since 2010, been on average 1% per annum above that for CPIH. So, adopting CPIH methodology for RPI going forward could reduce the rate of increase of rents calculated under RPI reviews by approximately 1% each year. This would clearly have a major impact on rental growth when compounded over time.

Although collars would assist landlords if RPI reduces dramatically, the collars and caps in existing leases may be out of line with the amended index, so tenants may seek to negotiate reductions of such amounts.

Most review clauses also provide for adjustments to RPI or a selection of an alternative index if there are fundamental changes in the method used to calculate the RPI. So if RPI is discontinued or if there is a material change in the method of compilation of RPI, some landlords and tenants may seek to agree adjustments to RPI or the selection of an alternative index (to be determined by an independent expert or arbitrator if the parties cannot agree).

How such provisions would apply to the proposed changes to RPI in practice depends on the specifics of the drafting.

However, what landlords and tenants don't need is disputes and uncertainty on each review date over what formula applies.

The UK Statistics Authority requires the Treasury’s approval before changing the RPI methodology because various Government gilts use RPI as a base index. The Chancellor’s consultation primarily focuses on obtaining public input on the impact of the proposed changes to RPI on gilts, but it acknowledges and asks for information on the widespread use of RPI in private contracts, such as leases.

There is still time to make representations.

The Association of Real Estate Funds (AREF) has drafted a response to the consultation on behalf of its members. They highlight that the proposed changes could reduce the rental growth seen across property funds’ portfolios and directly carry through to reduce funds’ projected total return and likely challenge the viability of funds' target returns.

This should be a concern for us all. A lot of those investors are pension schemes and local authorities, who rely on distributions to meet their liabilities and could have a shortfall if funds do not meet these target returns.

Landlords who have large portfolios of RPI-reviewed leases may wish to provide further responses to the consultation paper before it closes on 21 August 2020, given the impact that the UK Statistics Authority’s proposals could have on their rental growth.

Any change is not likely to be immediate - the discussion is suggesting a change from 2030, but that could be brought forward to as early as 2025, and so would certainly catch a lot of the current leases which are in place. For the meantime, when drafting new leases, consideration should be given to the wording around index changes, and to the use of other indices, such as CPIH or the Consumer Prices Index, which may afford the certainty the market needs, and which RPI may no longer offer.


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