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.
RPI is used widely across the economy as a measure of inflation, including for rent reviews in leases. In recent years, there has been a shift away from open market reviews towards index-based reviews, to avoid lengthy disputes between parties, provide certainty and reflect inflation.
However, 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. 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.
Despite RPI’s acknowledged flaws, the UK Statistics Authority have proposed amending the methods and data sources for calculating RPI, rather than abolishing it entirely at this stage.
The UK Statistics Authority is minded to use 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. These changes to RPI methodology would be implemented at some point between 2025 and 2030.
The measured rate of RPI annual inflation has, since 2010, been on average 1% per annum above that for CPIH. As a result, 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.
Most index-based rent review provisions in leases contain future-proofing provisions. For example:
- Collars and caps: these provide minimum and maximum annual increases. 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, especially if Covid-19 puts tenants in a stronger negotiating position.
- Adjustments to RPI or selection of an alternative index: where RPI is discontinued or where there is a material change in the method of compilation of RPI, some leases provide for the parties 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, complicated adjustments to RPI could result in disputes and uncertainty on each review date, which most parties are looking to avoid when choosing index-based reviews over open market reviews, and alternative indices (such as CPIH) could result in similar reductions to the increases in rent.
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.
The Association of Real Estate Funds (AREF) has drafted a response to the consultation on behalf of its members. In its response, AREF highlights 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. A high proportion of investors in long-income property funds 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. AREF therefore argues that the proposed changes to RPI methodology would not be an equitable or justified transfer of economic benefit from fund investors to tenants.
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.
However, although the RPI proposals may cause concern in respect of ongoing leases, in this period of uncertainty regarding the future of RPI, we have seen trends for index-linked rent reviews in new leases to be based on other indices, such as CPIH or the Consumer Prices Index, and for shorter leases with fixed increases in rent across the term.
Impacts from the change to the RPI could therefore have unintended and diverse impacts, affecting the public finances, economy, financial markets or certain groups of users.