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Indexation of payments under a lease agreement – which index should be used?

Waloryzacja świadczeń z umowy najmu

In the period from 2000 to 2020, inflation in the European Union rarely exceeded 2.5%. Inflation in Poland was slightly higher, but in this case as well, prices remained significantly stable at that time, and there was even a period of deflation in 2014-15.

Although an important element of all commercial space leases concluded on the market, indexation clauses were not usually an issue of great interest to the negotiating parties, or particularly controversial.

This has changed in the last ten or so months, when price increases in certain months exceeded 10% year on year (overall for EU countries) and 16% in the case of Poland. It became clear that the indexation of rent in 2023 would be painful for tenants and there would be many discussions that had been avoided up until that time.

Even the question alone of which index is to be applied to the indexation of payments under a specific lease agreement can be controversial.

Due payments specified in euro in lease agreements are adjusted according to the harmonised indices of consumer prices (HICP) published by Eurostat. The HICPs are published in several main tables.

The first and main one (monthly data (index)) shows the HICPs for individual months, and incorporates the basic premise of the index methodology, which is that 2015 is the reference year and the index value is taken to be 100 for that year. The HICPs give the cost of a representative basket of consumer goods and services at a given point in time, i.e. the end of the calendar month, for which the index  is calculated. Individual EU Member States calculate the index for a given month usually by the end of the following calendar month, but sometimes the indices are still revised further.

The indices for particular months, based on a common denominator for 2015, cannot be used directly for adjustment purposes. The values useful in this respect are obtained only by comparing the indices for two selected points in time, which tell us the relative change in prices per unit of time.

Subsequent tables published by Eurostat contain precisely the relative values obtained in that comparison (division) of the indices for selected months.

What is annual inflation?

The values in the monthly data table (annual rate of change) illustrate the change in prices in each month year on year. The values for December are of particular interest in practice – as they actually show the change in prices between the end of one year and the end of the next, which we intuitively perceive (rightly) as annual inflation. For the EU, this value was 10.4% in 2022, for the euro area 9.2%, and for Poland 15.3%.

In our view, these values should be the basis for the indexation of rent where the indexation clause refers generally to the “price increase index for the previous calendar year”. A comparison of price levels at the beginning and at the end of a given calendar year reflects precisely the increase in prices since the last indexation.

It will not always be appropriate to use the calendar year as the reference period. Many leases provide for indexation on the anniversary of the commencement date (for example, at the beginning of June). In this case, the basis for adjustment (unless the lease agreement explicitly states that a different value should be used) should be the year-on-year change in the price level index for the month preceding the anniversary of the start date (in this case, May).

In addition to the year-on-year change table, Eurostat also publishes monthly change rates (monthly data table), i.e. changes with respect to the previous calendar month.

What about the average annual inflation rate?

The next two tables (monthly data (12-month average rate of change) and annual data (average rate of change)) present, among other things, average rates of price change (it is worth noting that, in each case, the average of the last twelve months for December of a given calendar year in the monthly data table is at the same time the average for that calendar year in the annual data table). In 2022, the average price growth rate was 9.2% for the EU, 8.4% for the euro area, and 13.2% for Poland (these are identical to the averages of the last twelve months for December 2022, and this follows from the basic premises – the end of December is also the end of the calendar year).

What do the annual average indices tell us? These values are calculated as arithmetic averages of the year-on-year change rates for the individual months of the calendar year. This means that they are calculated according to the year-on-year change rate for: January 2022 (compared to January 2021), February 2022 (compared to February 2021) and so on up to December 2022 (compared to December 2021). This index calculation tells us  the average rate of price growth over the course of a calendar year (in this case 2022). Is it reasonable to use this index to adjust the payments due from the tenant?

If the purpose of rent indexation is to adjust the rent in line with the current rate of price increase, using the annual average index does not achieve this purpose. In principle, using this index means that by carrying out the adjustment in March 2023 with effect from the beginning of 2023, we are using among other things data on the rate of inflation from the first quarter of 2022 year on year, which was many months ago. The annual average index has statistical and historical value at this point – it informs us about the past inflation rates – the rate at which the current price level was reached on average – and not about the level of price change itself.

To illustrate this, let us imagine that prices in the economy remain stable for nine months from the beginning of the year, but in October there is an external shock (e.g. a collapse in the raw materials market), as a result of which the rate of price increase rises to several percent. In this case, the average inflation rate for the calendar year will be relatively low (given the stability of prices in the first part of the year), but the actual year-on-year change in the price level will be disproportionately higher. It can, of course, be said that the increase in prices as a result of the shock will be reflected in the year-on-year indices for subsequent months and, consequently, raise the average inflation rate in the following calendar year. In practice, however, this means postponing the real indexation of payment. Particularly when prices increase rapidly, using the average annual index is beneficial for tenants, while for landlords it delays the adjustment of the rent to the new market price.

The table below illustrates the differences in comparing the annual index and the average annual index. As can be seen, the differences can be significant and, consequently, the actual level of indexation of payment may differ from that expected.

A specific type of HICP should, of course, be used as stated in the lease. If the indexation clause does not state this explicitly, in our view, the intended purpose of the clause, which is essentially to realign (adjust) payments with the current value of money and prices, should be taken into account.

When negotiating the agreement, the issues related to the methodology of constructing the various types of indices need to be borne in mind, in order to precisely define in the agreement the basis for the indexation, thus avoiding future disputes.

Although some macroeconomic data suggest that inflation has now peaked, high inflation is likely to stay with us for a long time. It may take years for annual inflation to stabilize again at around 2%, and this means that indexation clauses will continue to be of particular interest to parties negotiating leases in the near future.