Should you use RPI indexation in property transactions? We discuss the issues in Estates Gazette.
The Retail Prices Index (RPI) is Britain’s oldest measure of inflation, but it has become increasingly discredited over the past few years, and the government is being urged by senior economists to stop using it, writes Katherine Lang.
RPI indexation can be found in many real estate documents, for example:
The right to use a substitute index is rarely unilateral and will often involve consultation between the parties. If the indexation or replacement index can’t be agreed, the parties may have a right to move to arbitration or expert determination to resolve the issue.
The bar for replacement of the relevant index is often set high. In many documents, RPI can’t be replaced unless:
A well-drafted legal document should include a right to replace the index, usually at the discretion of the payee. If it doesn’t, and RPI ceases to be published, the court may imply that the closest alternative index is used, in place of RPI in the document, or the court may order that an average indexation figure or the most recent indexation figure is used. The alternative is that the means of indexation is frustrated and therefore indexation can’t be carried out. The position is uncertain and the outcome would be up to the courts.
As RPI is still being used, there shouldn’t be any cause for concern if legal documents currently refer to RPI-linked indexation. However, parties may want to review relevant legal documents and consider a course of action in the event that RPI does cease to be published.
In addition, tenants can use substitution of an index as a bargaining chip. For example, if the tenant has a break right in a lease and decides not to exercise it, the tenant may be able to suggest that in exchange, CPIH is substituted for RPI in the rent review provisions.
At the outset, when negotiating legal documentation, parties should take detailed advice on the most appropriate index to
use. Possible alternatives include the Consumer Prices Index including owner-occupiers’ housing costs (CPIH) and the Consumer Prices Index (CPI).
CPIH is about one percentage point lower than RPI. Since March 2017, it has been the UK’s lead inflation index, and the Office for National Statistics (ONS) currently considers it to be the most comprehensive measure of inflation.
CPI also continues to be published and is used in the government’s target for inflation. The ONS states that it is produced to international standards, and in line with European regulations. Currently it is about 0.7 percentage points lower than RPI.
CPIH reflects housing costs for owner-occupiers as the rent that an owner would have to pay to occupy their home – this appears to be the best way to reflect the value of what is partly an investment, in a price index. CPI does not include housing costs.
The worked example (see below) shows the effect the different indices may have on the index-linked review of rent in a lease. For instance, CPI and CPIH-linked reviews may result in smaller rent increases than a review linked to RPI. This clearly shows why landlords prefer RPI, and why tenants favour CPI or CPIH.
As RPI is still published, the choice of index may depend on the negotiating position of the parties to a transaction.
If indexation is used in a rent review clause, it’s important to consider stamp duty land tax (SDLT).
It is normally the case where a rent is variable, unascertainable or uncertain, that the tenant must make a reasonable estimate of the rent payable for the first five years of the term, with the highest estimated amount payable in any 12-month period in the first five years being used to calculate the SDLT payable.
However, there is a unique exception for rents subject to RPI indexation – in this case, any increases are disregarded when calculating the SDLT payable. The same does not apply to indexation based on CPI or CPIH.
As a result, the SDLT payable may be slightly higher if RPI is not used, but this should be reviewed on a case-by-case basis.
RPI is an increasingly discredited index and no longer a national statistic, but it still persists in many real estate documents. As it generally runs higher than CPI or CPIH, it continues to be favoured by many landlords and developers.
It’s important to remember that even in well-drafted legal documents it can be difficult to substitute an index once it is agreed, unless this is part of a broader commercial deal between the parties.
In new documents, the parties may consider asking their lawyers to include additional factors to trigger replacement of any index that is used, but this should always be discussed at an early stage of negotiation.
The parties also need to consider the tax implications – the SDLT treatment is slightly more favourable for an RPI-linked rent, and this should be weighed against the otherwise lower rent that may be payable if CPI or CPIH is used.
In 2015, the UK Statistics Authority published an independent review of UK consumer prices statistics, led by the economist Paul Johnson.
The review agreed with the view set out by the national statistician that there are basic statistical flaws in the construction of RPI, and that it is not a good measure of inflation.
When speaking to the House of Lords’ Economic Affairs Committee on 30 January 2018, the governor of the Bank of England, Mark Carney, called for a “deliberately and carefully timed withdrawal” of the RPI, because it has “known errors” and “no merit”.
Additionally, the Treasury Select Committee advised that the government must stop using RPI for any indexation purpose where legally possible, although it has recently been reported that the chancellor of the exchequer has rejected this proposal for the time being, on the basis that this would have an adverse effect on the government’s tax revenues.
At present, RPI is still used for determining issues such as rail fare increases, but the government no longer uses it for pensions, benefits and tax allowances.
We have an imaginary lease, dated 25 March 2015. The annual rent payable at the date of the lease was £100,000 pa.
There have been annual index-linked rent reviews since the date of the lease.
The lease contains the following formula for index-linked rent reviews:
New rent = current rent x A/B
A = the figure shown in the relevant index for the month immediately before the relevant review date
B = the base index (being the figure in the relevant index for the month immediately before the last review date)
Current rent = the rent payable for the year before the current review date
Let’s run through this formula, using in turn RPI, CPI and CPIH as the relevant index.
Note that the figures for each of the indices are taken from the Office for National Statistics at: https://www.ons.gov.uk/economy/inflationandpriceindices
2016: Rent payable 2016-17 = 100,000 x 260/256.7 = £101,285.55
2017: Rent payable 2017-18 = 101,285.55 x 268.4/260 = £104,557.85
2018: Rent payable 2018-19 = 104,557.85 x 278.1/268.4 = £108,336.58
2016: Rent payable 2016-17 = 100,000 x 99.8/99.5 = £100,301.51
2017: Rent payable 2017-18 = 100,301.51 x 102.1/99.8 = £102,613.07
2018: Rent payable 2018-19 = 102,613.07 x 104.9/102.1 = £105,427.14
2016: Rent payable 2016-17 = 100,000 x 100.1/99.5 = £100,603.02
2017: Rent payable 2017-18 = 100,603.02 x 102.4/100.1 = £102,914.58
2018: Rent payable 2018-19 = 102,914.58 x 104.9/102.4 = £105,427.14
This article was first published in Estates Gazette on 6 June 2018.