- The UK letting market is seeing an increase in turnover rent requests for new and existing leases, particularly in the retail sector.
- The relevant turnover model applied in such cases may depend on factors including the nature of the business and the length of the term.
- Capturing turnover requires careful consideration of existing trading arrangements, whilst anticipating changes in the way tenants conduct business in increasingly innovative ways.
In more detail
The UK's real estate market, particularly its retail, leisure and hospitality sectors, has been hit hard by the effects of COVID-19. The government-imposed lockdown measures, enforcing closure of leisure, food and beverage and non-essential retail premises for much of 2020, exacerbated existing problems for bricks-and mortar retail resulting from longer-term changes in shopping and streaming habits. Despite moves to cushion the blow felt by tenants, through temporary restrictions on forfeiture and rent recovery, business rates relief and grants, both landlords and tenants are concerned about the sustainability of tenants’ businesses.
In response to trading pressures, many retailers are now seeking more flexible lease arrangements, with shorter lease terms and, in many cases, a shift in the rental model from the traditional open market rack rent to a turnover-based calculation. Whilst an open market rent provides predictable tenant costs and landlord returns, it is inflexible, and often unsustainable, in a market downturn. The turnover rent alternative, whereby the amount of rent is calculated in part or whole by reference to the turnover which the tenant achieves from the premises, is becoming increasingly common in UK retail, leisure and hospitality leases.
Turnover rents are not a one-size-fits-all solution, and the calculation metrics, once relatively "standardized", now involve consideration of a wide range of permutations particular to individual trading models. At the outset, the turnover rent principle adopted will generally fall into one of three types:
- Straight Turnover Rent - a "pure" turnover rent calculated by applying an agreed percentage to the tenant's gross* turnover (such as imposed by the recent New Look CVA)
- Modified Turnover Rent - applies an agreed percentage to the amount by which the gross*
turnover exceeds an agreed threshold, often the base rent
- Threshold Turnover Rent - the turnover element of the rent is the amount by
which the agreed percentage of the gross* turnover exceeds the base rent. This method is possibly the most commonly accepted at present. It requires a higher percentage and therefore tends to be more sensitive to turnover (though often rewards the landlord less for the same percentage by comparison with the other methods).
*Gross turnover will largely reflect only deductions for VAT, returned goods, goods traded in, and defective goods.
Generally speaking, whilst evidence suggests that straight turnover rents are on the rise (particularly for smaller, short-term lettings or pop-ups), a tenant's turnover rent will at present usually be based on a (reduced) base rent, with an additional top-up calculated on a turnover basis (with or without a cap on maximum rent amounts). The base rent will typically be around 75% or 80% of the property's open market rental value, and the percentage applied to turnover will be calculated accordingly: the lower the base rent, the higher the percentage, and vice versa. The turnover percentage is a matter for negotiation, often dependent upon the profit margins associated with the particular type of business. That percentage might be fixed for the duration of the lease term, or variable (e.g. to reflect changes of occupier or use, or wider changes in market practice or sector performance). However, landlords will still be aiming for a target rent, and the turnover model and percentage calculations will have that target in mind.
Turnover rent is widely viewed as a way for landlords and tenants to share the dual risks of market and economic uncertainty, and alterations in shopping trends. Difficult trading conditions might result in a reduced rent for landlords, whereas an upsurge in customer spending might elevate it, with turnover rent allowing the landlord to benefit from the tenant's increased returns. Though many recent turnover arrangements have been imposed on landlords through a surge in CVAs over the last 12 months, there are also signs that landlords and tenants are increasingly willing to collaborate and compromise on long-held rental expectations, e.g. through the voluntary restructuring of leases, to ensure business survival and avoid empty premises and rental voids. From a tenant's perspective, turnover rents help to insulate it from the worst effects of a decline in trade, whilst actively incentivising landlords to support and promote the premises to maximize returns to both parties.
The restructuring of a lease into a turnover rent arrangement is not simple, and nor is negotiation of new, turnover-based lease terms. There needs to be a balance between what turnover is captured as rent, and what is actually affordable for a tenant, both in the current economic climate, and following a move into a period of recovery and renewal. Moreover, drafting of turnover rent provisions has to both reflect, and anticipate changes in, trading circumstances. The landlord will want to capture revenue sources emanating from market developments and foreseeable trends such as significant increases in online trading, as well as from increasingly innovative methods of business generation, for example experiential retailing.
There are, of course, various "standard" captures, such as traditional point-of-sale purchases reflecting sales from, and attributable to, the premises. However, altered trading practices, particularly in relation to online sales, mean that this no longer provides an accurate, or reasonable, assessment of turnover. Recent research from Moody's has found that the UK is experiencing the highest online retail penetration in Europe, and analysts predicted that 25% of total UK retail sales will be generated online over the coming three years. As retail stores find themselves increasingly treated as showrooms facilitating online purchases, landlords are looking for ways to capture the influence of stores on online sales when calculating turnover rents. Research suggests that online sales are on average 106% higher within a store's sphere of influence, and that 90% of all UK retail spend continues to be influenced by a store.
So, it is now relatively standard for in-store click-and-collect revenues to be included in turnover. But what about click-and-collect kiosks outside the main store, in the car park? Though not common in the UK, they are widespread in the Asia-Pacific region and should arguably be included in scans of potential trading trends.
Where online purchases are returned in-store, should these be netted off that store's turnover? What about stores with heavy footfall but low trade - what if internet returns cancel out store revenues, thus allowing the retail tenant to achieve a very low turnover rent?
There is also a growing trend for purchases made via an app. For example, in the UK coffee retailers Pret and Leon have launched a subscription coffee service whereby customers can pay a monthly subscription for unlimited coffee. A QR code is scanned in-store on collection of their coffee. Does the notional cost of this coffee count towards store turnover?
Other turnover issues
Turnover capture isn't the only complication. Others may include:
- Base rent increases - open market or index-linked review? If the latter, which index should be used. In the UK, the Retail Prices Index (RPI) runs higher than the Consumer Prices Index (including owner-occupiers' housing costs) (CPIH) and is therefore the obvious choice for landlords (though the UK Statistics Authority is likely to align RPI with CPIH in 2030).
- Should the turnover rent arrangement be personal to the named tenant? Some UK landlords prefer to include open market rent provisions in the main lease, and house the turnover provisions in a side letter. If the lease is to contain the turnover rent provisions, it must also include stringent alienation provisions (such as a landlord's pre-emption right or a switch to open market rent on tenant disposal) and keep open controls (with provisions for rent calculation in the event of unauthorised closure).
- Shared occupation with concessionaires/franchisees - landlords will want to receive a fair share of the revenue for shared space, for example through a) a lease assumption that turnover is generated at the same rate in the concession as in the rest of the premises, b) inclusion of turnover generated by the concessionaire, c) inclusion as "gross sales" of any payment made by the concessionaire to the tenant, or d) an agreed open market rent for the concession area in consideration of its exclusion from turnover calculations.
- Transparency - landlords expect transparency from tenants to enable accurate assessment and verification of tenant turnover. A funder would expect a thorough assessment of the tenant's calculations in case of issue with rent received into any charged rent account, and appropriate lease drafting is critical though controversial. High profile and prosperous tenants might not want to share information on turnover with their landlords. Such issues may turn on better data capture and sharing between landlords and tenants.
- Administrative burden - turnover arrangements undoubtedly impose a greater administrative burden on both parties in terms of record-keeping, and the supply, verification and processing of financial information. Precise and comprehensive lease drafting is required to ensure that issues are anticipated and resolved.
Of course, turnover rent is neither the only rental alternative to a rack rent, nor the only solution to changing market trends. All-inclusive rents, with the tenant paying a flat rate, and the landlord bearing the risk of fluctuations in the cost of insurance, services, rates and property maintenance, can fit well with short term lettings of smaller premises where landlords are eager to fill space and tenants want certainty of outgoings.
Germany has seen mall operators adopting an opportunity-based rent, whereby the mall owner accepts responsibility for footfall to the premises, and the tenant pays rent based on such footfall. In such model, it is incumbent on the tenant to maximise its profit from that "opportunity". Press reports suggest that Hammerson may be considering a similar model in the UK. Other creative and flexible rental models, such as those allowing rental of space by the hour or day, give occupiers a platform to test a locality, and the market generally, before committing to a longer term commitment, and to learn, through AI-driven data analytics, about customer footfall and engagement.
The government has announced an imminent review of 'outdated' landlord and tenant legislation in early 2021, including in relation to alternative rental models. Whilst details are the review are awaited, landlords and tenants prepare themselves for permanent change in the way that rents are calculated, particularly in consumer-driven sectors. It is anticipated that turnover rents will form part of that government review, and part of the commercial real estate landscape for some time to come.
Baker & McKenzie recently hosted The Future of Bricks and Mortar Retail webinar in partnership with The Oxford Real Estate Society which considered many of the issues highlighted, and a recording of that webinar can be accessed here.
For further information and to discuss any of the issues mentioned in this alert, please get in touch with your usual Baker McKenzie contact.