Rents and other payments are often required to be index linked, but which index should they be linked to? The choice of index can make a significant difference to the result of the calculation. The most widely used indices of inflation are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI) but there are also many others which might be more appropriate in particular cases. The recent consultation on proposed changes to RPI methodology has brought the issue into the news.
RPI versus CPI
RPI and CPI are both produced by the Office for National Statistics (ONS). RPI has been produced for more than sixty years; its younger brother, CPI, was first produced in 1996, using methodology harmonised across the EU, and in 2003 became the Government’s preferred measure of inflation. Longevity is an important consideration when choosing an index for a lease or agreement with a fairly long term. Both these indices are likely to be around, in roughly comparable form, for as long as needed.
RPI and CPI both measure the change in prices of goods and services bought by households, so they do not include commercial expenditure such as wages, business rates or commercial rents. For that reason, they may not be the most appropriate indices for uprating commercial rents or payments.
The basic approach of the two indices is the same – they track the changing cost of a fixed basket of goods and services by combining around 180,000 individual prices for almost 700 items. However, there are many differences in the methodology used. For example, the RPI covers only private households but excludes the top four per cent of households by income and pensioner households mainly dependent on state benefits, whereas the CPI includes all private households and also institutions such as student accommodation. An important difference is that the CPI does not include some owner-occupiers’ housing costs, such as mortgage interest payments, Council tax and buildings insurance.
The main factor in the difference between the two indices is the so-called formula effect, which relates to the method used to combine the individual prices. For most items, the RPI uses simple averages, the “arithmetic mean”, by which the index values for individual items are added together and the result is divided by the number of items. However, the CPI uses the “geometric mean”, also called the Jevons formula, by which the index values for individual items are multiplied together and the nth root is taken (where n is the number of items). The Jevons formula takes into account changes in spending patterns as prices change, such as switching to shops or brands with smaller price increases, whereas the arithmetic mean does not. The Jevons formula will always give a lower result than the arithmetic mean.
“CPI will be lower than the RPI except when interest rates, and therefore mortgage interest payments, are falling rapidly.”
The important practical result is that the CPI will be lower than the RPI except when interest rates, and therefore mortgage interest payments, are falling rapidly. Therefore, as a general rule, the payer (the tenant in a rent review) will prefer to link to CPI and the payee (the landlord in a rent review) will prefer to link to RPI.
Another difference to consider is that the RPI is never revised once it has been published but in principle the CPI could be revised. Therefore an index-linking clause referring to CPI ought to specify that the calculation will not be changed to take account of revisions made after publication.
Indices derived from RPI and CPI
The ONS also publish a range of other indices derived from the RPI and CPI including:
CPIY: removes the effects of VAT and excise duties
CPI-CT: assumes VAT and excise duties have not changed since the previous January
RPIX: excludes mortgage interest payments (so RPIX may be higher or lower than RPI but will always be higher than CPI)
RPIY: removes the effects of VAT, excise duties and Council tax
RPI/CPI components: show inflation for particular sets of items, such as food or clothing.
“RPIX may be higher or lower than RPI but will always be higher than CPI”
“RPI-J will always be lower than RPI and fairly close to CPIH”
Two new measures will be introduced this year:
CPIH: will include owner occupiers’ housing costs (but using a different method from the RPI, “rental equivalence”, which is the estimated rent an owner occupier would need to pay to live in the property if he did not own it); and
RPI-J: removes the formula effect from RPI (so will always be lower than RPI and fairly close to CPIH).
It is not really logical to link commercial rents and payments to an index of consumer price rises; there are many other indices which may be more appropriate, both government produced and private; some are mentioned below. Whichever index is used, it is advisable, in a long term lease or contract, to provide for a suitable alternative index to be substituted if the chosen index should cease to be produced, with disputes over the choice of alternative index to be settled by an independent expert.
IPD: The Investment Property Databank produces a monthly index and a quarterly index of total return from retail, office and industrial property based on data from actual transactions by institutional investors and property companies. It also provides data for the property rentals component of the Services Producer Price Index published quarterly by ONS.
House price indices: ONS produces a monthly house price index using data from the Land Registry; Halifax Bank and the Nationwide Building Society also produce indices of house prices but based on figures for their own mortgage lending and therefore less comprehensive and each using different methodology.
BCIS: The RICS’ Building Cost Information Service produces a large number of different indices including a tender price index by sector, region and trade (such as structural steelwork, plumbing etc), building cost indices by construction type (such as steel framed, brick etc) and type of cost (such as labour, materials, plant etc). There are also indices of maintenance costs, maintenance materials cost, lift service labour cost, cleaning cost and energy cost. There is also the ABI/BICS house rebuilding cost index which is used for insurance purposes. BCIS data is also used by the Department for Business Innovation and Skills to produce quarterly construction price and cost indices.
* I am grateful to Michael Baxter MSc CStat, formerly Head of Methodology for Consumer Prices at the ONS, for his help in researching and writing this article.