As inflationary winds whip across the globe, having the right leasing terms in place has never been more important. Indexed lease contracts, which include provisions for adjusting the rent based on changes in an inflation index, allow landlords to maintain the purchasing power of their rental income over time, and offer predictability to tenants. Despite their potential application across a full range of commercial and residential lease types, there is significant geographical divergence in their use, requiring investors to do their due diligence across different territories.
Different ways of protecting rental income against inflation risks
“Law in Europe is very much a national matter,” explains Joaquim Mendes, Chief Legal, Tax and Compliance Officer at Sonae Sierra. “However, we are increasingly seeing alignment in the terms of leases, evidencing the exchange of best practices and solutions to common problems.” As chairman of retail real estate body the ECSP Legal Working Group, Mendes recently oversaw the execution of a Europe-wide survey of shopping centre leases in 36 countries. “The report shows that landlords are on the whole protected against the impacts of inflation thanks to largely robust leases,” Mendes adds.
Notes Union Investment’s Head of Asset Management and Management Board member Volker Noack: “Most of our lease agreements in Europe offer protection against inflation, either through a price adjustment clause, i.e. indexation, or predetermined rent increases.”
However, national differences are significant, Noack says, pointing out that while in Germany, the Consumer Price Index (CPI) is the leading index used as a benchmark in leases, in France, the Cost of Construction (CCI) Index dominates. “As in Germany, property managers apply and implement these clauses. In countries where this form of index does not exist, we also work with predetermined rent increases or the statutory options for adjusting rents,” he explains.
Anecdotal evidence suggests that global investment funds have often favoured continental Europe because of the prevalence of indexed leases. Rory Buck, Clarion Gramercy’s Head of Acquisitions for Europe, notes: “The majority of our portfolio is fully index-linked, and we are starting to see the benefits of this, with double-digit rental uplifts in territories such as the Netherlands.”
Law in Europe is very much a national matter. However, we are increasingly seeing alignment in the terms of leases.
Rent growth depends on the ability to agree higher rents
Yet the situation in Asia Pacific, the US, and even the UK tends to be quite different. In Asia, indexation is infrequent, but shorter lease terms combined with frequent rent revisions help to protect the value of rents. Similarly, CPI increases are atypical in the UK, but short rental contracts have helped landlords revise rents upwards in the past. However, recent research from Fitch Ratings suggests that short leases in the current economic climate may not provide the same protective mechanism going forward. Fitch Ratings describes the rental growth outlook as “pedestrian” for the UK and warns that high rent hikes may be less palatable for tenants in 2023. The ratings agency therefore predicts a low-single-digit annual rent increase for lease expires.
Adds Matthew Scholl, Head of Investment Management Americas at Union Investment: “In the US, indexed leases are not standard market practice – we tend to have graduated rental agreements. The increases are fixed when the lease agreement is concluded and are also included in the planning as fixed amounts.”
Overall, the lack of indexed leases has not proved an impediment to rental growth, but has rather created a stable calculation basis for tenants and landlords and, in a long-term comparison, has at least compensated for inflation, he says. “We are unable to generate any additional income from the current higher CPI, but in case of doubt we have secured rent increases even in the event of deflation.”
He continues: “In the case of residential leases with an average term of 12 months, rents are in effect adjusted annually in line with the market. So far, the adjustments have been upward, and for our multi- housing properties in Florida we are currently around 15 percent ahead of expectations in terms of net rental income.
By Isobel Lee