UK: Index-Linked Or Index-Bound?

Last Updated: 25 September 2013
Article by Malcolm Dowden

In January 2013 the Office of National Statistics (ONS) announced that, contrary to media speculation, publication of the retail prices index (RPI) will continue. The decision to create an additional index (RPIJ) rather than discontinuing and replacing RPI was justified by the "significant value to users in maintaining the continuity of the existing RPI's long time series without major change, so that it may continue to be used for longterm indexation and for index-linked gilts and bonds in accordance with user expectations".

That decision aimed to balance the acknowledged shortcomings of RPI against potentially adverse economic effects if the longest established basis for indexation were wholly removed and replaced by an index likely to produce lower returns on those longterm investments. That rationale is both clear and pragmatic in the context of gilts and bonds, but may produce concern rather than relief 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). RPI dates back to the late 1940s, and is UK-only, while CPI conforms with a European template drawn up in the 1990s. CPI excludes, while RPI includes, owneroccupier housing costs. Crucially, the indices use different averaging techniques to convert individual price quotes into item indices. The RPI uses arithmetic averages whereas the CPI generally uses the geometric mean, an approach that usually comes up with a lower figure when working out inflation. That difference is the "formula effect".

The ONS found that the RPI's arithmetic formulation (the "Carli" index formula) is the main source of the formula effect, and concluded that it does not meet current international standards. Consequently, RPIJ will be published from March 2013 using a geometric formulation (the "Jevons" index formula). The geometric mean is preferred on the grounds that it captures the behaviour of consumers who buy less of a product when it gets dearer; by contrast, the arithmetic mean assumes in effect that they do not respond this way. Moreover, the arithmetic averaging technique used for RPI is not permitted on methodological grounds under European rules for the CPI. As long ago as 2003, the ONS said that very few countries used the technique, which can generate an upward bias known as "price bounce" when the index is chain-linked across years.

Retail issues

This disparity between RPI and CPI figures for clothing inflation emerged as a major concern during 2010. RPI clothing inflation for women's garments showed as 16% in November and 13.8% in December. Those figures were disputed by the British Retail Consortium, whose shop-price index (calculated using geometric means) showed clothing and footwear prices actually falling by 1.9% in December 2010.

RPI and commercial leases

RPI is widely used as the basis for indexation in key areas of commercial leases. It is used as an alternative to open market rent review, providing the landlord with an uplift in rent, often annually, to track changes in the value and purchasing power of the 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 effect of the parties' original allocation of risk for maintenance and capital expenditure. In each case, the parties' objective is to recognise that, unlike a contract for a single transaction, a lease forms the basis for a commercial relationship intended to last for several years. Its terms cannot be constantly renegotiated, so adjustments made by reference to an objective measure of broader economic factors provide a commercially fair approach.

However, RPI has often been used as an uneasy compromise. It has been selected not because it is the most appropriate index for the job, but because of extraneous and potentially distorting factors. However, landlords and tenants have opted to use RPI to avoid the risk of additional charges to Stamp Duty Land Tax being triggered by any future uplift in rent based on indexation. That decision stems from Finance Act 2003, Schedule 17A, paragraph 7. It provides that future increases can be disregarded 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 prices index (sometimes called the "factory gate" prices index). In the retail sector, the same reasoning has led parties to adopt RPI rather than the more modern measure of 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 (less often) if it is rebased. The ONS decision to add a new index is highly unlikely to engage those provisions. RPI will continue to be published. and where the parties to a lease have agreed to use it, they will continue to be bound by that index.

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:

  • requests for lease variation where tenants consider that continued indexation by RPI would generate rent increases that do not accurately reflect market factors
  • arguments for the replacement of RPI clauses on lease renewal under the Landlord and Tenant Act 1954
  • criticism if adherence to RPI can be identified as a factor pushing tenants in vulnerable sectors, such as High Street retail, towards insolvency.

However, the argument is not risk-free for tenants. While RPI has generally produced higher figures than CPI that is not inevitably the case. During 2009 rapidly declining mortgage payments briefly produced a negative RPI figure, while CPI's low point was 1.1%. Further, 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Malcolm Dowden
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