The income strip market
For the purposes of the currently-booming income strip and commercial ground rents market, the concern here is not about market rent review (which will have a potentially major impact the commercial property market) but the proposal to abolish collars on rent reviews. As those in the market are aware, the current market position is for there to be an annual indexed review, increasingly to a CPI measure, with a cap and collar on the level of uplift in any one year. That may be a 0% collar and 5% cap depending on commercial arrangements. The level of the cap and collar will depend on the individual transaction negotiated and collars are sometimes higher (although rarely above 1%).
The effect of the Bill
The draft legislation seeks to limit indexed reviews so that they can never be calculated to be more than “the reference amount” (which is for this purpose the actual index figure). If the rent review clause has a collar on it, then prima facie the position will be that the rent review clause will be invalid to the extent of the collar and will take effect at the actual reference amount, i.e. the indexed figure. The rent review will not be overturned just limited in this way.
Whilst this will probably not impact the income strip and commercial ground rent market, there is a provision that allows a tenant to trigger a rent review even if not allowed under the lease so it can capture lower reviews. There is an anti-avoidance clause in the Bill which will capture attempts to subvert the law by measures to avoid its effects in some way. That is broadly drafted so it will be difficult to tell what may be avoidance in advance, and the courts could be called on for decisions in due course.
Of course, the Bill does nothing to challenge a cap on a rent review.
Also, existing leases and leases that are granted before the Bill becomes law or granted pursuant to a contract pre-dating the change in law will not be captured.
Impact on investors
This will impact investors as they have always had rent collars in this market and that will no longer be possible following the Bill becoming law.
However, the reality is that inflation rarely, if ever, actually becomes negative. We have analysed inflation in the UK from 1960 to 2023. Only once (in 2015) in all that time has inflation ever fallen below 0% although it may be that on a CPI measure there may have been one or two other occasions when it has done. It is rarely below 1% (only for a period in 2015-16 and 2020-21, the latter very much a Covid outlier). It will of course have more of an impact if collars are 1% or higher. In fact, given inflation history in the UK over recent decades, the risk has more often been of breaching the cap likely to be agreed at around 5-6%.
It may well be that investors end up taking comfort from this and may also enable them to push for higher caps as a quid pro quo for taking the risk on inflationary shortfall.
The unknown at the moment is how this will play out for:
- Matching adjustments; and
- Ratings.
Most of the investors in this market are pension insurers setting off their annuity liabilities and very much governed by the requirements of Matching Adjustments under Solvency UK. These are complex and will require some careful review along with regulators in the context of this change and that may have an impact on the use of the collar. Also, many of these transactions are externally rated and the view of the rating agencies will be most interesting to see if they perceive a problem in the giving of a rating.
