COMMENT Last year, at Colliers we published a report exploring the merits and drawbacks of rent reviews linked to inflation. Focused on the industrial and logistics sector, we tested the hypothesis that an occupier might prefer an index-linked review over an open-market review. The research was conclusive – past performance shows that, from an occupier’s perspective, an open-market review will result in lower rents payable in the long term.
That was obviously good news for landlords with index-linked rent reviews. With caps and collars, these reviews have traditionally offered landlords secure income that keeps pace with rising prices. The caps and collars are a safety mechanism which ensure positive and fixed growth, while simultaneously leading to higher rents generally than the open market. Until now.
The tables have turned
Inflation is rising at its fastest pace in 40 years. The annual UK inflation rate increased to 10.1% in July 2022, the highest level since February 1982, and has remained high, reaching 10.1% again in September. The Bank of England predicts that inflation will continue to rise before returning towards its long-term target of 2% in around two years’ time.
Several scenarios might be imagined as to how aggressively the BoE will bring inflation back to target, and whether it is likely that it might tolerate higher inflation with lower interest rates for a longer duration to ensure domestic economic stability or in order to erode the national debt in real terms. However, recent experience with the unfunded mini-Budget illustrates that the UK economy is subject to the whims of global capital, and that to move out of sync with global markets is not likely to be tolerated by global investors, even if it means eroding the national debt.
The most likely scenario is that high inflation will prove to be transient. The current transitory inflation spike was anticipated, but it has been aggravated by geopolitics and supply chain disruptions. Nevertheless, it remains a spike. The BoE will use all available levers (interest rates, quantitative tightening and forward guidance) to reduce inflation back to its government-mandated 2% target.
Unprecedented inflation has brought index-linked rent reviews into sharp focus. What has been traditionally perceived by institutional landlords as a mechanism to protect against inflation, providing secure reversionary income, is now compromised. Why? Because invariably index-linked rent reviews include caps and collars, typically at around 2% to 4% annually. A cap is the upper limit, while a collar sets the minimum rental uplift. Our research found that between 2000 and 2020 the collar was much more important than the cap, coming into play far more regularly.
The tables have turned, however. If there are caps in play, landlords should be concerned that persistent high inflation is actually damaging to income streams pegged to inflation: a 4% cap on rental increases is not an attractive prospect for any landlord when annual inflation is hovering around 10%. The cap is critical, because it means the reversionary income stream is no longer “inflation-proof”. This is bad news for property funds, as investors may look to other asset classes – such as equities – that tend to perform well during periods of rising prices and therefore offer a better, unrestricted, hedge against inflation.
Crystal ball gazing
The extent of the damage caused by high inflation depends on how quickly it will take to return to normal levels. This requires an element of crystal ball gazing, but it is likely that the BoE will pursue tight monetary policy, to avoid a lasting domestic embedding of high inflation, but also to remain in sync with US Federal Reserve policy. When US Fed policy turns, so too will UK BoE policy. The key indicator of the government’s intentions will be how far interest rates rise in the coming months. Rates are predicted to rise sharply, before falling steadily back over the next two to four years.
All the indicators suggest that inflationary pressures are mostly transitory and that inflation will start to recede in Q1 2023. The government may be tempted to sustain some level of inflation and keep interest rates low, but the UK’s open economy militates against such an approach as the recent international response to the mini-Budget suggests.
Landlords currently exploring index-linked rent reviews with collars/caps should proceed with caution, recognising that there may be an element of short-term pain for long-term gain. Inflation is very likely to return to normalised levels between 2% and 4% in the next 18 months, barring any further “black swan” events. It may take slightly longer than the BoE will have us believe, but in the long term this should give landlords some comfort that the index-linked rent review will be restored as a darling of cautious investors.
Janek Szkoda is a surveyor in Colliers’ business space lease advisory team
