Indexation Based Rent Reviews
Review of rent in a lease by reference to movements over a period of time of the Retail Prices Index (“the Index”), has some advantages over review by reference to comparable market rents.
The process, if the provision is worded fairly, achieves relative certainty for landlord and tenant. This is attractive to landlords who can match forecastable increases in income with liabilities and to tenants, particularly retailers, whose outgoings are closely linked to movement in the Index. These types of provisions are also useful where the premises let are unusual and may not have sufficient comparables to allow a market rent to be established on review.
Such provisions can be used in the grant of a reversionary lease, that is a lease which creates a term which starts at some point in the future. At present such leases are being entered into as a means of extending the term of a lease to allow a landlord to recoup, in the future, rental concessions being given under an existing lease. In such reversionary leases, indexation of the existing rent payable is used to arrive at the rent payable at the point in the future at which the lease term starts.
For such a comparatively simple process, however, case law would suggest that there is a tendency for badly or loosely drafted indexation clauses to result in litigation. This article examines why this should be the case and what the practice of the courts is in settling disputes over such clauses.
How does an indexation review work ?
Although there are variants, an indexation review needs to identify three basic constituents:
- The figure which is to be increased by the reference to increases (assuming an upward only rent review) (“C”);
- The figure which is taken as the baseline from which increases in the Index are measured (often known as the “Base Figure” but in this article referred to as “A”); and
- The comparable figure which gives the amount of the increase in the Index as at the review date (“B”).
These are then expressed in a formula (B/A) x C to give the revised figure.
The intention in employing the formula is to allow the figure being reviewed (C) to be increased to counteract the effect of inflation that figure over a period of time concerned. To achieve the desired effect the figure to which the increase applies and the period of time over which the increase is being measured need to be consistent, the simple alternatives being to use the Index:
- To measure the increase in the rent initially payable from the date that rent became payable to each date on which it is to be reviewed; or
- To measure the increase in the rent payable as at the last date of review to the date on which the rent is next subject to review.
How indexation clauses go wrong
The two most common drafting errors in such clauses are:
- “compounding” on a review. This happens where the clause provides, by reference to the above formula, for C to be a figure that has already been reviewed and increased and where A remains a fixed date. Examples of this can be seen in the decisions in:
Arnold v Britton  UKSC 36: a review provision that provided for a service charge of £90 in 99 year leases to be increased by 3% every year in some or every three years in others. Each 3% increase applied to the previously revised £90 thus compounding the increase so that the annually reviewed service charges would probably reach a figure of £1,025,004 by the end of the term of the lease.
Monsolar IQ Limited v Woden Park Limited  EWHC 1407 (Ch): the application of 5% increases to previously increased rents would have led to the rent increasing to £76,000 towards the end of a 25 year term as opposed to £30,000 if a non-compounded increase had been applied.
- The second most common error is for A to have no relevance to the figure being reviewed (C). An example of this can be seen from the decision in Trillium (Prime) Property GP Limited v Elmfield Road Limited  EWCA Civ 1556. In that case the Base Figure (A in the formula above) adopted for a review of rent in 2010 (was the Index as at September 2005 but the rental figure (C in the formula above) was the rent prevailing in 2010 rather than 2005. That gave an indexed rent of £1,595,253.63 against a figure of £1,282,835.31 if C had been the 2005 rent.
How do the courts approach disputes over indexation provisions?
Generally, it is the tenant who is disadvantaged by an indexation clause containing one of the common errors. A tenant may choose to try and deal with the issue by way of challenging the interpretation of the clause.
In doing so, the tenant faces a fundamental problem in that the courts’ approach is to interpret the wording of a clause in a contract in the light of the “natural and ordinary meaning of the words used “. In doing so, a court:
- will not depart from that natural meaning even if, according to that meaning, a contractual arrangement has worked out badly, or even disastrously, for one of the parties (as was the case in Arnold); and
- will be slow to reject the natural meaning of a provision as correct simply because it appears to have been a very imprudent term for one of the parties to have agreed to, even with the benefit of hindsight (as was the case in Trillium).
An alternative basis of challenge on interpretation is to seek “corrective construction”. In Chartbrook Limited v Persimmon Homes Limited  1 AC 1101, Lord Hoffman said that if it was objectively clear that a mistake had been made and it was clear what the mistake was, there is not
“a limit to the amount of red ink or verbal re-arrangement or correction that a court is allowed. All that is required is that it should be clear what a reasonable person would have understood the parties to mean”.
In Trillium, the tenant argued that C should be the rent that was payable in 2005 and not that payable in 2010. This clearly departed from the natural and ordinary meaning of the clause as drafted and the tenant argued that this departure was justified because the meaning of the review provisions was ambiguous.
The Court of Appeal (Lewison L.J.) disagreed, holding that there was no such ambiguity and that, absent the same, the clause had to be interpreted as it appeared in the lease. In addition, even if there had been an error, it was not clear what a reasonable person would have understood the parties to mean as there were three alternative solutions to the perceived error identified by the tenant.
In Monsolar, the tenant fared better in a corrective construction argument. In that case, the judge agreed that there was clearly an error in the drafting of the indexation provisions. The resultant compounding of the rent at review was not something that could have been intended as it made no sense, it was “inherently arbitrary and irrational”. There were also indications in other clauses of the lease that it was the current rent that was to be reviewed, by the application of the Index on an annual and cumulative basis and not the initial rent. The judge also felt able to identify a clear and reasonable alternative in indexing the current rent by reference to increases in the Index since the last review.
Rectification as an alternative
Another hurdle which a tenant seeking to apply an interpretation which departs from the natural and ordinary meaning of clause must surmount is that the court cannot consider pre-contract negotiations in deciding what the parties intended a clause to say. However, if the departure argued for is based on a claim for rectification such pre-contract evidence is admissible. Thus a tenant might be better off, in such a case, trying to make a case that a landlord and tenant had established a common intention as to how indexation provisions would work prior to the lease being entered into but that the lease does not reflect that common intention.
Where that can be proven, a court will allow a rectification claim for the wording to be changed to reflect the common intention. Such an argument might have prevailed in the Arnold and Trillium cases where the tenant was seeking to justify changes to the clauses in the leases concerned as drafted.
Indexation based reviews may increase in popularity in the present economic climate if market rentals in an unpredictable letting market are more difficult to establish. Documenting such provisions should be relatively straightforward if the fundamentals of drafting such clauses are observed.
However, there are still many historic leases with indexation provisions, the effect of which was not necessarily apparent at the time that they were drafted (as in Arnold) or which were the product of “home-made” drafting (as in Monsolar). Vigilance in dealing with such leases, given the difficulties of getting such provisions changed is still, therefore, required.