Real Estate

Commercial Lease Indexation Clauses in Times of Inflation

Indexation clauses that link rents to the consumer price index (CPI) have long been common in commercial lease agreements. After receiving only little attention in past years due to rather moderate index changes, such clauses are becoming increasingly significant as high inflation means the revenue commercial tenants can generate is often unable to keep pace with the scale and frequency of rent increases.

Legal basis for the agreement of indexation clauses

Whether or not indexation clauses are permitted in commercial lease agreements is primarily determined on the basis of the Price Clause Act (Preisklauselgesetz, “PrKG”). According to this Act, indexation clauses are lawful if (i) they are sufficiently specific, (ii) the relevant agreement has been concluded for a period of at least ten years or the landlord waives the right of ordinary termination for this period/the tenant has the right to extend the term of the agreement to at least ten years, (iii) the rent is determined by the change in the CPI or a price index prepared by a state statistical office or the Statistical Office of the European Community and (iv) the parties are not unreasonably disadvantaged by the agreed clause. Such a disadvantage exists in particular if an increase in prices results in a rent increase but a drop in prices does not result in a rent reduction (so called ‘upwards only’ clauses). If an indexation clause violates the above requirements, it is considered to be invalid as of the time of the legally binding determination of the violation.

However, the PrKG does not contain any provisions that place a limit on rent adjustments in the event of an unusually large change in the index. Moreover, commercial lease agreements rarely provide for such clauses either, because there has been little reason to do so to date.

What options do the affected tenants have?

Ultimately, termination for cause without notice (section 543 Civil Code (Bürgerliches Gesetzbuch, “BGB”)) is likely to be impermissible, since the interference with the agreement is not attributable to the landlord – let alone the landlord’s fault – but is rather due to external circumstances beyond the parties’ control. Moreover, it is rarely in the interest of the parties to terminate leases prematurely when more flexible solutions can be found instead.

One option that can be considered is asserting a claim for amendment of the agreement according to the principles of interference with the basis of the transaction (section 313 BGB). Such interference is deemed to have taken place if (i) circumstances that became the basis of the agreement have subsequently changed significantly (so called factual element), (ii) the parties would not have concluded the agreement or would have concluded it with different content had they foreseen this change (so called hypothetical element) and (iii) the party demanding the amendment cannot, taking account of all the circumstances of the specific case, reasonably be required to adhere to the unchanged agreement (so called normative element).

The Federal Court of Justice has not yet clarified whether the principles of interference with the basis of the transaction apply in cases involving dynamic changes in the CPI. It is true that in cases where an agreement did not contain an indexation clause, the court ruled that the risk of an usual decrease in purchasing power is generally borne by the tenant, so that such a decrease does not trigger any rights under section 313 BGB and consequently does not provide the basis for interpreting the lease as if it contained an indexation clause. However, no conclusions can be drawn from this for scenarios in which the agreed indexation clauses ultimately prove to be “too effective”.

It is ultimately unlikely that the principles developed in the context of the COVID-19 pandemic can be applied. Firstly, the pandemic situation was an unexpected, singular event for which parties typically made no contractual provisions, while inflation is usually subject to fluctuation. Secondly, it is doubtful whether the effects of the COVID-19 pandemic are comparable to those of high inflation. Whereas in the coronavirus cases it was at times not possible to use the leased premises at all or only to a very limited extent – so that what was received in exchange for the rent had essentially been reduced in value – rent increases based on an indexation clause can be (at least partially) offset by increasing sales or passing the higher costs on to customers.

All things considered, there are probably better arguments for not applying the principles of section 313 BGB:

  • It is questionable whether it can indeed be presumed – and how it can be proved – that the parties expected only a moderate increase in the CPI (or at least, that the landlord was able to discern that the tenant didn’t expect more than a moderate increase). Moreover, if the parties’ expectations concerning price fluctuations are already integrated into the agreement itself through the inclusion of an indexation clause, they become part of the agreement’s content and cannot simultaneously serve as its basis. Also, amending the agreement is not an option when a risk materialises that one party alone must bear. As a general rule, the landlord bears the risk for monetary devaluation, while the tenant bears the risks associated with securing funds and financing. This means, however, that the tenant also bears the inflation risk. The fact that section 313 BGB also encompasses what is known as the fundamental basis of the transaction – including the expectation that the key political, economic and social circumstances underpinning the agreement will not change due to war, hyperinflation or natural disasters – ultimately does not help, either. Instead, it is evident from relevant case law that this provision is only concerned with significant upheavals that directly impact the specific agreement, such as revolutions and wars (in Germany) or inflation rates substantially exceeding the present level. It is therefore more than doubtful whether a period of elevated inflation triggered by various factors qualifies as interference with the fundamental basis of the transaction – especially if it is (presumably) of manageable duration. After all, there must have been a serious change of circumstances. If an indexation clause was agreed in the lease, then fluctuations in inflation were intentionally and explicitly incorporated into it, meaning that the pertinent circumstances have ultimately remained unchanged.
  • Rights under section 313 BGB moreover only exist if the party affected by the interference with the agreement cannot reasonably be expected to adhere to the agreement. This presupposes that performing the agreement would lead to an intolerable outcome that is simply incompatible with law and justice – something that must be determined by weighing up all the interests involved and taking all the circumstances into account. Although it could be argued that a drastic increases in energy prices, for example, were almost impossible to foresee, only the risk of price fluctuation – and not the specific factor triggering that inflation – needs to be apparent. Tenants already know from their own experience that the inflation rate changes from time to time and can rise sharply under certain circumstances. So the fact that the parties decided to include a specific indexation clause makes it clear that they were aware of the opportunities and risks involved. Finally, it should not be forgotten that tenants have definitely benefited from index-linked leases in the recent past because of the moderate inflation rate, which means that the current rent increases are only of limited significance in the overall context.

Amending the agreement by mutual consent

Since this means that neither the premature termination of the agreement nor a claim for amendment according to the principles of interference with the basis of the transaction is likely an option, it is up to the parties to reach agreements on the amendment of the lease, which take their respective interests adequately into account. There are many ways of doing this, but they all raise numerous legal questions.

  • The most obvious way of dealing with unusually large index fluctuation is to amend the contractual indexation clauses. It can be agreed, for example, that the rent may only be adjusted if a certain threshold is reached or exceeded or only after certain periods have expired. It can also be stipulated that only part of the index change will be passed on to the tenant. Such contractual amendments are, however, only permitted within the limits laid down in the PrKG.
  • The parties can also leave the indexation clauses as they are, while agreeing that they will not apply or will be replaced by another adjustment mechanism (such as graduated or sales-based rent) for a limited period. However, it is important to specify when the suspension of the indexation clause will take effect and end and how the suspension will work – for example, by clearly stating what index level will apply to rent changes once the indexation clause has come back into force.
  • Finally, it may be possible to agree on a form of commercial compensation that reduces the tenant’s payments while maintaining the contractual indexation clauses, for example by granting rent-free periods, rent reductions or deferrals, assuming the costs for modernisation work and/or investments or capping operating and other ancillary costs. Many potential incentives can be considered here. Which one is chosen and how it is implemented will depend on the circumstances of the individual case, in particular the landlords’ financial room for manoeuvre as well as the pressure on tenants to reduce costs.

Summary and conclusion

Since the legislator has not yet laid down any provisions governing an unusually large change in the CPI and the Federal Court of Justice has not yet ruled on the associated legal issues, it is up to the parties to ensure that indexation clauses are amended appropriately. When doing this, they must in particular stay within the limits set by the PrKG. They must also ensure that the contractual amendments do not violate the statutory written form requirements, which would result in a right to terminate the agreement prematurely. This ultimately represents a stress test for many lease agreements – with both parties facing opportunities and risks in equal measure.