Bill Chandler of Hills Dickinson writes:
Linking lease rents to inflation is an easy and increasingly popular way of ensuring that rental income from commercial property does not lose touch with the market.
Protracted rent review negotiations and frequent disputes are replaced with a simple mathematical formula, allowing the new rent to be calculated in a matter of seconds and without a ‘comparable’ in sight!
But before we all consign the traditional open market rent review to history, here are five important questions to ask about index-linked rents.
1.What index should I use?
When I first encountered index-linked rents, the Retail Prices Index was the chief barometer of inflation, but RPI has long since been dethroned by the Consumer Prices Index and it is a long time since I saw a lease that used anything other than CPI. A well-drafted lease should anticipate the possibility that the index could be replaced or rebased during the term of the lease, but there is always a risk that the adopted index lingers on, increasingly unloved and untrusted.
2. Should I interfere with the index?
A pure index-linked rent will simply track inflation, which as we have seen in recent years can result in minimal increases or even decreases. Most landlords will want to ensure as a minimum that the lease does not allow the rent to go down in a deflation scenario, while ‘collar and cap’ arrangements are increasingly being used to ensure a guaranteed minimum rental growth.
3. How do ‘collar and cap’ arrangements work?
Collar and cap is a commonly-used mechanism to set a maximum and minimum increase on each review. So, for example, a collar of 2% and a cap of 5% ensures that the rent will always increase between 2% and 5% per annum on each review, even if the index has increased by more or less than those figures. Just remember that the collar and cap need to be compounded if the rent is not being reviewed annually, so that a 2% per annum collar becomes a chunkier 10.4% if the rent is only being reviewed every 5 years, while the 5% per annum cap becomes a whopping 27.6%.
4. How often should the rent be reviewed?
The ease and speed with which the rent can be indexed means that it can be reviewed more often. Index-linked rents are frequently reviewed annually, although we are also seeing many leases that feature index-linked rents retaining the traditional three or five-yearly review pattern.
5. What’s the downside?
Indexing offers a quick, easy and cheap means of reviewing rents, but it assumes that open market rental values will follow inflation, which will not always be the case. The longer the term and the more the lease interferes with the index, the greater the risk that by the end of the term the indexed rent may no longer reflect the open market rent for the property.
This article was originally published on Place Resources.