Following the recent consultation on changing the formulae to calculate the Retail Prices Index, John Condliffe reviews the possible fallout for the real estate industry.
Changes to the purpose and make up of investors’ real estate portfolios over recent years including, in particular, the increased focus on a liability driven investment (LDI) strategy, has resulted in a number of funds investing in real estate assets which produce income linked to the Retail Prices Index.
An LDI strategy seeks to balance cash flow with future liabilities. This differs from the historic approach where pension funds focused on their assets achieving better returns than an external index and less on changes in the liabilities. This approach assumed, amongst other things, that there would be limited volatility between the assets and the liabilities and the corporate would be able to make contributions if there was a gap.
Changes in the economy have resulted in greater funding level volatility between assets and liabilities. An LDI strategy seeks to address this by dividing the portfolio into two parts: one that manages liability risks (LDI); and one that produces appropriate investment returns.
Pension liabilities last for many years and are linked to inflation, interest rates and longevity. The LDI part of a portfolio aims to match the investments to these factors. This means that if interest rates or inflation change unexpectedly, investments and liabilities rise or fall together and the funding level of the pension scheme should be less volatile.
Many pension funds are therefore starting to invest in real estate assets which produce income which follows factors other than traditional open market rent. These assets include sale and leaseback transactions, in which a number of funds have made significant investments over the past few years, where rent increases are linked to increases in the RPI.
In October, the Office for National Statistics published a consultation on options for amending the way that the RPI is calculated. The consultation closed on 30 November 2012.
Respondents were invited to consider options for bringing the calculation of the RPI in line with the Consumer Prices Index. The Treasury estimated that annual increases in the CPI are approximately 0.5% lower than those of the RPI, although some commentators think the difference can be up to 1%.
This change could have a significant impact on a number of real estate structures, both existing and proposed.
Both indices are calculated according to the cost of a notional shopping basket of different kinds of goods and services bought by a typical household. As the price of those goods and services changes over time so does the total cost of the basket.
The differences between the RPI and the CPI relate to:
- population base (the RPI excludes very high and low income households);
- commodity coverage (the CPI excludes owner occupiers’ housing costs); and
- the different formulae used to combine prices at the first stage of calculation.
It is this last aspect that was the subject of the consultation. The difference between the RPI and the CPI figures at shopping basket level is caused by the different calculations: the RPI uses arithmetic averages but the CPI uses a mixture of arithmetic and geometric averages. An arithmetic mean is calculated by adding the prices and dividing by the number whilst a geometric mean first multiplies the numbers and then the nth root is taken so that the range of prices is evened out. These different methods can produce very different results from the same data; in 2011, following a change in how the data was collected, the CPI for the clothes and footwear sector rose by 2.3% but the RPI for the same sector rose by 11.5%. This difference was largely due to the “formula effect”.
Although the consultation was primarily about statistical methodology, there are many potential consequences of any change. Some of these would be far reaching. As the official measure of inflation, the RPI is used for a variety of purposes including the adjustment to index linked Government bonds. If the RPI is recalibrated then this could mean lower returns for funds which have invested heavily in index linked Government bonds.
The Office for National Statistics has now announced the timetable for the decision process on the consultation. Over 400 responses were received from a large number of individuals as well as a wide range of organisations, including trade unions, pension groups and private businesses.
On 8 January 2013, the Consumer Prices Advisory Committee will meet to discuss ONS’s response to the issues raised in the consultation. CPAC will consider the statistical points raised by respondents and ONS’s reply to them and provide advice to the National Statistician.
The National Statistician will announce the recommendation at 07.00 on 10 January 2013. If necessary, the recommendation will be sent to the Bank of England and then to the Chancellor of the Exchequer for their consideration. Any changes are likely to be introduced in March 2013.
Impact on real estate sector
Despite the many uses of the RPI in real estate, the real estate sector was not mentioned in the consultation, which focused on Government bonds, regulated charges such as rail fares, taxation rates and private sector pension funds.
Many leases provide for increases in rent and other sums to be linked to increases in the RPI. This is particularly the case for sales and leasebacks where the occupiers require cost predictability. A link to the RPI should give investors predictable rental growth. The RPI is also used: to calculate increases in the uniform business rate; in service charge caps; and in swap rates in financing transactions.
Particular issues for existing real estate instruments
Some leases deal with what happens if the RPI ceases to be published, is rebased, or the method used to compile the RPI is changed. Such clauses may provide that the parties will agree a suitable replacement index, or continue as if the method had not changed. Other leases are silent on what happens if there is a change in the methodology.
Changes in the methodology could therefore result in uncertainty in the index to be used, or a lack of transparency when trying to operate rent review provisions. If changes in the methodology have a significant effect on the rent payable, this could result in detailed negotiations where reaching agreement may be difficult, or possibly litigation. Caps and collars may mitigate the effects of any uncertainty, but will not deal with the underlying problem.
If the investor and occupier have made assumptions on the increases in the RPI, the result may be a change to the commercial deal, and there could be a negative effect on valuations.
The changes may also have effects on existing financing of commercial property investments. There may be a reduction in the value of any existing RPI swaps. Lower than expected increases in rents may cause borrowers difficulty under any existing loan facilities.
Issues to think about for the future
In addition to the effects on existing structures which may be caused by the changes, with increasing reliance on RPI-linked investments investors and occupiers should consider similar issues when putting structures in place in future.
The lease mechanisms should ensure that the changes can be catered for without changing the fundamental aim of the lease provisions. This change could be to the method of calculation (as is the case in the current consultation), a rebasing of an index, or the abolition of an index.
Some leases already seek to do this (for example by triggering a change to the index used if the coupon rate on specified gilts changes or the gilts can be redeemed, or by requiring an expert to nominate an alternative index).
However, given the likelihood of increased use of leases with indexed rents, additional techniques may need to be developed to try to cover all changes which may happen during the terms of such leases, which can often be for 25 years or more. In addition the increase in popularity of such leases will require a greater understanding of the mechanics of the calculation of the various indices by lawyers, fund managers and others.
To avoid or limit any uncertainty, other mechanisms may become more popular, for example the use of different indices or a blend of indices, or simple fixed uplifts.
The current consultation may spell the end for the RPI as we know it. For leases that have already been negotiated the issue will be whether such documents include any room to manoeuvre with the calculation. Even the ability to re-negotiate a similar equivalent is unlikely to be a practical solution.
A shift to liability driven investment means that this issue will become more and more important for investors. Real estate assets will need to follow that trend in order to preserve their allocation within the funds’ portfolios. Until the results of the consultation are released early next year, it remains to be seen whether the future will breathe new life into the RPI.