The coronavirus pandemic has thrown a number of industries into turmoil, but arguably none more so than the retail and hospitality sector, who have spent the last 18 months in and out of lockdowns with restrictions dictating when and how they can operate. This has led to a record net deficit of 9877 chain stores permanently closing in 2020.
Turnover rents have been one of a number of measures designed to protect commercial tenants during this period of heightened risk and economic uncertainty, but are they here to stay?
What is a turnover rent?
A turnover rent is a rent which is calculated by reference to the income received by the tenant at the property. There can be many different types of turnover rents, for example those which are set as a straight percentage of turnover, and others which are formed on the basis of a guaranteed base rent with a premium which becomes payable once turnover reaches a certain threshold. Regardless of the style, the common feature of turnover rent is that, when business is good, tenants pay more, but where markets fall, so do the rents payable on the premises. Base rents with turnover top-ups tend to be popular with retailers and restaurants in shopping centres/high streets, whereas pure turnover rents are better suited to outlet retailers where tenants are generally on short form leases.
The exact terms and percentages of turnover provisions are something to be negotiated and agreed in each case, however research from Savills has suggested that retailers can expect a rate between 1% and 15%, with the average being 7%.
Before agreeing a turnover rent, there are a number of factors that need to be considered, for example the suitability to the business model, whether other costs payable under the lease are to be kept separate from the turnover provisions, how long the provisions should last and what might happen if the tenant wishes to assign the lease. The biggest bone of contention, however, has been the calculation of turnover under the provisions.
On the face of it, turnover should be quite simple to calculate however, in practice, this exercise has posed difficulties. One of the many reasons for this is the shift in retail landscapes, with shoppers opting to use ‘click and collect’ services instead of more traditional methods of trade. Arguably, the income generated is not linked to the leased premises itself, but created in the homes of customers. One suggested solution is to look at how the click and collect orders are fulfilled, and whether stock already at the store is used to fulfil a customer’s order, or whether it is sent from a distribution centre for pick up. Whilst this places an administrative burden on the tenant, it may be a sensible solution to an issue which is yet to be decided by the courts. Restaurant operators will similarly need to ensure that the order is being fulfilled from the premises in question and that staff tips are not caught by the turnover calculation.
Needless to say, turnover formulation is something to be considered when negotiating a turnover rent to avoid disputes later down the line, and parties should seek legal advice before agreeing to provisions. If a turnover calculation is especially complex, consider including a worked example in the lease or even in the initial heads of terms.
Are they here to stay?
Yes! Despite the challenges and complications that accompany turnover rent provisions, it is clear that this method of rent is becoming increasingly popular. A nationwide survey commissioned by Savills found that 82% of retailers will be looking to incorporate turnover rent provisions in future leases.
Landlords would, of course, prefer a fixed income with certainty around how much rent they will receive. However, with the decline of the traditional high street, accelerated by the pandemic, landlords may be more willing to consider turnover rents if it helps to maintain security of occupation and rent, particularly as landlords could stand to receive a higher rent overall. Turnover rents have frequently been seen as part of Company Voluntary Arrangement (CVAs) structures, in an effort to restore profitability to struggling businesses.
Turnover provisions can also ensure that both parties to the lease remain invested in the success of the business premises, with both shouldering the risk. In other retail environments, this idea has been taken further, with a shopping centre in Germany trialling ‘opportunity-based rent’. Under this model the rent paid by the tenant is linked to the footfall in the shopping centre, based on the principle that it is the landlord’s responsibility to attract people into the shopping centre, and the tenants’ to convert footfall into sales.
Despite increasing popularity for the flexibility of turnover rents, there remain concerns over the practical difficulties inherent to them. In addition to the complications mentioned above, tenants may also have concerns over sharing high level, sensitive business information with their landlords. Careful consideration would need to be given as to how confidentiality is protected under the lease, and each business must consider its suitability in every case.
For landlords, there may be issues with lender consents where rental income becomes contingent, and the added complexity of enforcing turnover provisions can dissuade landlords from entering into such agreements in favour of more traditional, fixed rents underpinned by static rent review clauses.
That being said, performance-based rents certainly have their market in today’s economic climate, and can be a commercial check and balance between landlords and tenants in a joint effort to protect the high street and ensure security of occupation. There will be a number of matters to iron out, however a well drafted lease should help avoid problems, and turning parties’ minds to these matters at an early stage can only be for the better.
This article first appeared in Property Investor Post