Indexation of rent: practical mistakes and court guidelines for businesses

Long-term lease agreements often provide for the indexation of rent. One of the most commonly used criteria is the consumer price index (CPI). In practice, the parties agree on the application of the CPI, but do not include more detailed provisions on the indexation mechanism and do not provide for possible risks.

According to Sandra Mickienė, senior lawyer at the AVOCAD law firm , such a "standard" formula may seem reliable at first glance, but improperly worded provisions can also have a negative impact. "In the event of unexpected changes in economic circumstances, the CPI may fluctuate so significantly that it could lead to a substantial increase in rent, particularly for large premises where the monthly rent is calculated in tens or even hundreds of thousands of euros," notes Mickienė.

So how can these risks be avoided and a balanced indexation mechanism ensured?

The consumer price index (CPI) is often chosen as the criterion for indexing rent in long-term lease agreements for several key reasons. First, the CPI is an officially published statistical value that reflects the overall change in the prices of goods and services in the country, and is therefore considered an objective indicator. Second, the use of the CPI provides the parties with a clear, easily understandable, and predictable basis for adjusting the rent, allowing them to maintain the economic balance of the agreement and protect the landlord from the effects of inflation. Thirdly, the CPI is widely recognized in the market, so its use helps to ensure transparency and reduce the risk of disputes over the amount of rent.

According to the lawyer, most often the parties clearly agree in the lease agreement on the specific index that will be used to recalculate the rent (for example, the change in the CPI over the year), indicate the source of its publication, and also determine the start date of its application and the calculation formula. Such wording is considered appropriate because both parties understand which indicator is used and how it will be used. However, in most cases, the parties do not establish a CPI "ceiling" or any exceptions or alternative rules that would apply in the event of extreme economic circumstances, such as a pandemic, energy crisis, or other atypical market shocks.

An AVOCAD lawyer warns that it is precisely in such situations that practical problems arise: the rental price may rise so suddenly and significantly that it becomes difficult for the tenant to maintain business stability. "Let's say a logistics company pays €200,000 in rent every month. If, due to a new economic crisis or pandemic, the CPI changes by, say, 20%, the rent recalculated according to the indexation rules set out in the contract would increase to €240,000. Such a sudden monthly increase of €40,000 could lead to a significant increase in the company's operating costs and pose a real threat of financial difficulties," notes S. Mickienė.

It is important to understand that, according to the Civil Code and court practice, the principle of pacta sunt servanda applies – a contract is binding on the parties as if it were a law. This means that obligations must be fulfilled even when it becomes more difficult or financially disadvantageous to do so. Normal business difficulties, market fluctuations, rising inflation, or even a pandemic are not usually considered sufficient grounds for changing the terms of a contract, especially when the contract is concluded by professional business entities that have a duty to assess the potential risks in advance.

According to case law, although it is impossible to predict specific extreme circumstances, such as a pandemic or geopolitical conflicts, business entities, when entering into long-term contracts, can and must reasonably anticipate that significant economic changes may occur over a longer period of time, leading to inflation. Therefore, if the parties themselves do not establish exceptions to the general rules for applying the CPI in the contract or do not set a "ceiling" for the application of the CPI, even a particularly significant increase in the index is considered a risk assumed by the parties.

However, the lawyer points out that the Civil Code provides for the possibility of requesting the court to amend the contract (for example, the mechanism for calculating rent) if circumstances arise that substantially alter the balance of the parties' contractual obligations. However, the application of this institution is not simple, as the aggrieved party must prove all the conditions set out:

1. that the circumstances arose after the contract was concluded;
2. that they could not have been reasonably foreseen at the time of conclusion of the contract;
3. that they were not under the control of the affected country; and
4. that this country had not assumed the risk of such circumstances arising.

It was precisely this type of argument that was used in one case by a tenant who asked the court to recognize that, under a long-term lease agreement, the rent should be indexed not according to the actual CPI, but by applying a 1.9% index. The tenant explained that due to the war in Ukraine and other economic factors, the CPI had jumped to 17.2%. The tenant claimed that such an unprecedented jump had fundamentally changed the balance of the agreement and therefore requested that the indexation mechanism be changed and a lower index be applied.

However, the Supreme Court of Lithuania stated that a significant increase in the CPI alone does not in itself mean a fundamental change in the balance of contractual obligations that would justify an exception to the pacta sunt servanda principle. The court emphasised that contracts must be performed even when performance becomes more difficult, and that the aforementioned principle can only be applied in cases of fundamental imbalance of obligations. The court explained that in the case at hand, the momentary jump in the CPI increased the rent by about 33.8%, but the total increase in the contract price was only 7.04%. This may complicate the performance of the contract, but it cannot be considered a change of such magnitude that would justify legal intervention in an agreement freely entered into by the parties. In addition, the tenant was in a strong financial position, so the increase in rental costs did not objectively threaten the continuity of its operations, and it is precisely this risk that is significant when assessing the impact of changed circumstances.

The court also noted that although the factors caused by the pandemic or war could not have been predicted, it is the index itself that should be considered a fundamentally changed circumstance, rather than the reasons that determined it. When entering into long-term (e.g., 10-15 year) contracts, business entities must reasonably anticipate that market fluctuations, including a significant increase in inflation, may occur during such a period. Furthermore, the provisions of the contract itself showed that the tenant assumed the risk of inflation – CPI indexation was established as unconditional and unlimited, and no indexation "ceiling" was provided for. Therefore, the parties agreed in advance on the distribution of risk, and the increase in the HICP, although higher than usual, does not fundamentally change this distribution.

Therefore, according to AVOCAD lawyer Sandra Mickienė, taking into account established court practice and the current economic situation, businesses are advised to negotiate additional provisions at the time of concluding the contract that provide for exceptions to the general rules for applying the CPI or to set clear indexation "ceilings."

The annual and average annual changes in different indices can vary significantly – in some cases by more than double. This means that in cases where the rent is indexed according to the annual change, tenants may face a significantly higher rent increase than those whose indexation is linked to the average annual change. "When negotiating a contract, consider what indices the parties would choose and how these indices have changed in recent periods. Such a preliminary assessment helps to better understand the real impact that indexation may have on the rental price and the risks associated with different indices," advises S. Mickienė.

The lawyer also suggests an alternative solution – linking the rent amount to the costs of maintaining and servicing the premises. If these costs increase significantly during the lease period, a price review mechanism can be established in the contract. Such provisions allow for a more proportionate distribution of risks and avoid a disproportionate increase in rent during a sudden surge in inflation.