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The Issues with Indexation

  • United Kingdom
  • Real estate



Eversheds Sutherland Property Column: January 2020

Many real estate documents provide for the indexation of payments or prices or costs throughout the life of the transaction. Increases in line with inflation (however measured) or in line with an alternative index, are often a valid and straightforward mechanism to balance the commercial interests for both sides of a deal.

One example is a rent review mechanism in a longer-term lease, providing for the rent to increase once every five years in line with inflation, rather than to the market rent at the time. Indexation as a rent review mechanism is increasingly common, partly driven by the increase in income strip and annuity leases. The mechanism gives a predictable and steady income stream suitable for setting off against long-time liabilities, such as pension pay-outs, or for providing the basis for an income bond. To protect against the unlikely spectre of deflation, and the more likely possibility of runaway inflation, such mechanisms often include "cap and collar" drafting whereby a minimum increase is imposed so that the rent can never fall, and the maximum increase is imposed above which the rent cannot increase notwithstanding a high inflation rate.

Indexation rent review mechanisms are also common in short-term leases, usually providing for an annual increase in the rent linked to the retail prices index. This gives an element of uplift for a landlord without having to undergo the more expensive exercise of a market rent review.

Indexation provisions are also often seen in documents other than leases, including purchase contracts, collaboration agreements, options and pre-emptions. A purchase price may be agreed several years in advance of completion, for example, where such a contract is conditional upon site assembly or planning permission conditions. The landowner will not want to see the price he has obtained be eroded by inflation before he receives payment, so will negotiate an increase in the purchase price to be calculated in line with inflation just before the completion date; likewise with longer term arrangements that may run for several years, such as collaboration agreements, options to purchase or pre emption rights. Of course, whilst an indexation increase means that the value of the money the seller receives won’t be eroded due to the passage of time, the indexation does not protect the seller in the event that land prices increase at a faster rate than inflation. So, indexation is only a partial solution there.

Rather than the rent or price, sometimes it is the costs incurred in connection with the contract that are to be the subject of indexation. For example, a developer might wish to link costs to the Building Costs Information Service’s House Rebuilding Cost Index, or its Tender Prices Index, as a way of reflecting increasing costs for materials and labour. Contributions that either party might be obliged to make towards phased infrastructure are also often subject to indexation, as the parties plan years ahead.

Fixed service charge contributions or service charge caps are also frequently subject to indexation, again most commonly in line with inflation. Just occasionally, particular elements of service charge cost are excluded from the indexation and capping, for example energy costs where the landlord is concerned that energy prices will rise significantly faster than inflation.

So, whilst useful, be warned, there is scope for all sorts of drafting errors in relation to indexation provisions. It is highly recommended that freehand drafting is avoided and a precedent used every time. Common mistakes include applying a single year’s worth of inflation each time, but only to the original figure, or conversely applying several years’ worth of cumulative inflation to the already increased amount payable the previous year. There is a fabulous section in the PLC practice note on Rent and Rent Review, which explains the cumulative effect of compounded indexation and caps and collars, highlighting the significant effects that subtle differences in drafting can produce (see Practice note, Rent and rent review).

Indexation provisions will often operate long term, so alongside careful drafting and peer review when indexation provisions are first drafted, the same level of care should be exercised when reviewing existing leases as part of an acquisition due diligence exercise for example. Much of the drafting depends on the definitions used, so the indexation rent review schedule should not be considered in isolation where the necessary definitions are elsewhere in the lease.

Most importantly, perhaps, is the question of which index is the most suitable for the context and the deal in question. Many real estate transactional documents refer to the retail prices index, some to the consumer prices index, and, as discussed above, for others documents it might be more appropriate to include reference to the building costs index. This is a commercial decision for the client and the choice can make a substantial difference, for example CPI has tended to increase at a lower rate than RPI over recent years.

Whichever index is chosen, it is a matter of good practice to include additional provisions alongside the maths to deal with what should happen if the index used is no longer published, or the basis on which it is calculated is fundamentally changed. For the retail prices index, this is a real possibility even if not in the short-term, as the UK Statistics Authority has proposed that publication of this particular index should cease. In response, the Chancellor has stated that he will consult on the issue early this year but that he won’t be giving his necessary consent to the end of publication before 2025 at the earliest. So, there is some time to consider alternatives, but, in the meantime, even more of a reason to provide within the drafting for a procedure to be followed should the RPI index disappear or fundamentally alter in its calculation.


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