Open Market vs Index-Linked: Which offers a better deal in UK logistics rent reviews?

Introduction

The UK logistics market is characterised by long-term leases. Throughout the lease term, “upward only” rent reviews are conducted, usually every five years. Reviews are typically calculated to market rental growth, index-linked uplifts, or some combination of the two.

With rental growth stabilising from the exceptional levels seen during the pandemic period, and inflation anticipated to continue moderating in the coming months, investors and occupiers may be wondering – which is the best option for them?

Whilst occupiers may be primarily concerned with limiting their future rent liability, investors need to consider a range of factors which could influence their total investment returns and asset liquidity. Creating the correct rent review provision is critical to maximising asset performance and should be given careful consideration at an early stage.

Hybrid Reviews

Perhaps the simplest answer to the question from an investor perspective is to opt for a hybrid provision. Using this approach, reviews are calculated to the greater of market rent and indexation, maximising rental returns.

In a market of tight supply and demand, this approach has become more prevalent in the logistics sector. Between 2016 and 2020, hybrid reviews accounted for 16% of all leases recorded by CBRE, whilst in the following three years (2021 to 2023), this increased to 24%.

However, with more normalised market dynamics, investors may find this option more challenging to implement moving forward, particularly outside of new build-to-suit and speculative properties. To increase utilisation, investors could negotiate in other areas such as the incentive package – given the improved value generation. But negotiation may not always be possible and parties may be forced to choose between market and index-linked provisions.

Historic Performance

Reviewing the historic performance of the UK logistics prime rent with CPI and RPI highlights the challenges surrounding the decision. Depending on the market’s supply and demand dynamics and the overall economic performance of the UK, one approach has outperformed the other at different points in time.

Between 2010 to 2013, the UK logistics prime rent remained flat, while CPI and RPI ranged between 3.1 to 4.7%, indicating an index-linked rent review would have outperformed. However, between 2013 and 2016, prime rental performance improved, making it the better choice. Following the surge in demand driven by the pandemic, UK prime rents grew on average 18.9% per annum between 2020 and 2022, significantly ahead of the most common index-linked cap of 3%. Most recently, in 2023, a market rent review approach would likely have outperformed. Despite the elevated levels of inflation, the cap commonly applied to index reviews would have limited potential growth.

Looking ahead, CBRE’s five-year forecast expects performance between the three metrics to be broadly comparable; our projections indicate that RPI will be the marginal winner, closely followed by market rental growth and then CPI. With this in mind, below we discuss other factors to consider when making a decision about rent review clauses.

Figure 1: Rent review analysis: Index-linked vs market rents

Market Reviews

The analysis above highlights key points in time where market rent reviews would have outperformed indexation, based on the UK prime rent. However, rental performance will vary significantly depending on the quality and size of the asset, as well as its geographical location. While prime rents continued to grow last year, with elevated vacancy rates, polarised performances are increasingly likely. For assets that have weaker growth expectations than the UK prime average, investors may want to consider whether an indexed approach is more appropriate.

Other pitfalls of the approach should also be considered, for example, the challenges associated with unusual building characteristics, limited transactional evidence, or poor drafting. These factors provide uncertainty which can result in protracted negotiations between parties and the possibility of third party referrals. All of which can increase the risk of adverse outcomes and additional costs, and become an unwelcome distraction for all involved. To limit the likelihood of these issues arising, we recommend practical steps are applied at heads of terms and the legal drafting stage. The key is to distil all the valuation considerations down to a single factor, which is readily discernible based on comparable evidence. This approach will help provide greater clarity and reduce scope for dispute.

Another issue with market-based rent reviews that is often overlooked is that they are typically calculated on a net effective basis, whereas when the lease was signed, the rent would have been on a headline basis. Using the net effective rent accounts for the impact of market incentives, typically provided in the form of rent free periods or capital contributions. Figure 2 highlights the effect of this approach on the level of market rental growth captured as part of a review; rather than reaching the full potential of the headline growth, the review will be limited to the net effective. This point is particularly pertinent for investors projecting internal rates of return.

Figure 2: Example of rent review calculation

Indexation

The principal advantage of an index-linked rent review is performance stability. With suitable cap and collar provisions, investors can guarantee an asset’s rental performance, whilst occupiers can accurately budget rent obligations during their lease. Another attraction to this approach is the limited scope for dispute and relative speed of the review process.

However, there are downsides as well. In periods of exceptional market performance, investors may be unable to capture the full growth, whilst occupiers risk paying over the odds if the minimum uplift exceeds growth. The parties would need to wait until lease expiry in order to re-base the rent to market levels, which, from an investor’s perspective, could present liquidity issues for assets that have become over-rented.

In some cases, pre-let deals are agreed on an index-linked basis to overcome issues linked to either an anticipated absence of readily available comparable market evidence, or bespoke building design features such as low site cover or high office content. However, if a market review is preferred, these issues can be overcome with appropriate artificial assumptions.

If parties elect to go down an indexation route, they will need to agree on which index of inflation should be used, and the appropriate annual cap and collar to be adopted.

Verdict

Although from an investor perspective, the hybrid “greater of” market and indexation combines the advantages of both, this is not always an option.

On a UK-wide basis, our forecasts expect performance between UK prime rents and the indexes will be broadly comparable. As such, parties should consider other factors when determining the next most desirable approach. These can include – but are not limited to – income or outgoing certainty, as well as time and cost constraints for the review process. Additionally, from an investor perspective, concerns around capital value and asset liquidity should also be considered.

In general, investors continue to show a preference for the flexibility of reverting market rents via an open market clause, as has been the trend in recent years. However, sentiment is beginning to change to a more neutral position, and with continued economic and political uncertainty, we anticipate investor and occupier preferences will continue to evolve during the remainder of 2024.

To avoid unexpected challenges, we recommend getting in touch with our experts at an early stage, when negotiating heads of terms, to assess the best approach for an individual deal.