From March 2013 the Office of National Statistics (ONS ) will publish new index of retail prices (RPIJ). However, it will also continue to publish the retail prices index (RPI). The decision to retain RPI aimed to balance its acknowledged shortcomings against potentially adverse effects if the longest-established basis for indexation were wholly replaced by an index likely to produce lower returns on gilts and bonds. That rationale is clear and pragmatic in the context of long-term investment, but may cause concern in the commercial property market.
What is the problem with RPI?
The ONS review was prompted by differences between RPI and the Consumer Prices Index (CPI). Crucially, RPI uses arithmetic averages whereas the geometric mean used for CPI usually comes up with a lower figure when working out inflation. That difference is the "formula effect".
The ONS found that the RPI does not meet current international standards. Consequently, RPIJ will be published from March 2013 using a geometric formulation, preferred because, unlike the arithmetic mean, it captures the behaviour of consumers who buy less of a product when it gets dearer.
Retail issues
As long ago as 2003, the ONS found that RPI can generate an upward bias known as "price bounce". The disparity between RPI and CPI figures for clothing inflation emerged as a major concern during 2010. RPI inflation for women's garments showed as 16 per cent in November and 13.8 per cent in December. The British Retail Consortium’s own shop-price index (calculated using geometric means) showed clothing and footwear prices actually falling by 1.9 per cent in that period.
RPI and commercial leases
RPI is widely used as an alternative to open market rent review, providing the landlord with rent adjustments tracking changes in the value of money received from tenants. Indexation may also be used to ensure that a cap on the tenant's obligation to pay service charge is adjusted to preserve in real terms the parties' original allocation of risk for maintenance and capital expenditure. Unlike a contract for a single transaction, a lease creates a commercial relationship intended to last for several years. Its terms cannot constantly be renegotiated, so adjustments reflecting an objective measure of market conditions provide a commercially fair approach.
However, RPI is often an uneasy compromise. Commercial landlords and tenants have opted to use RPI to avoid the risk of additional charges to Stamp Duty Land Tax on any future uplift in rent. Finance Act 2003, Schedule 17A disregards future increases for tax purposes, but only if they are "in line with the retail prices index". Given the tax risk, RPI has been used even for industrial premises, where rent adjustment might be more appropriately achieved by reference to the producer or “factory gate” prices index. For retail, similar reasoning has led parties to adopt RPI rather than the more modern CPI.
Changing the basis?
Lease clauses providing for indexation, whether of the rent or of any cap on liability, usually provide for change if the chosen index ceases to be published or is rebased. The ONS decision to add a new index is highly unlikely to engage those provisions. RPI will continue to be published and parties to a lease who agreed to use it will continue to be bound.
The good news element for commercial landlords may be more apparent than real. Indexation by RPI might produce higher rent figures than other indices. However, RPI is now known to be methodologically questionable and not compliant with international standards. Commercial landlords might therefore face:
However, the argument is not risk-free for tenants. While the Stamp Duty Land Tax regime remains unamended, the choice of index might still be influenced, if not determined, by the RPI's exclusion from future tax calculations. For now, therefore, both landlords and tenants might be compelled to stick with the devil they know.
About the authors
.jpg "Simon Ewing, Partner, Charles Russell")
Simon Ewing is a Partner in the Charles Russell Real Estate service. Simon deals with all aspects of commercial property but specialises in complex investment transactions, acting for a broad range of clients including UK institutional funds, trusts, corporate occupiers and overseas investors acquiring real estate through both onshore and offshore vehicles.
.jpg "Malcolm Dowden, Consultant, Charles Russell LLP")
Malcolm Dowden is an environmental and regulatory lawyer, specialising in the clean technology and telecommunications sectors. He has experience of both contractual and legislative drafting relating to renewable energy and energy performance. Malcolm is a drummer, bodhran player and Welsh rugby fan.
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