Turnover rents are becoming increasingly popular in today’s uncertain economy as a means of staving off the threat of tenant insolvency. Karen Mason and Amanda Gray discuss the benefits and disadvantages
The economic climate has led to increasing tenant default and restructuring (see EG 11 July, p80). Pre-pack administrations are now an everyday occurrence and landlords must be ready to negotiate with administrators and new companies.
Fixed rents are also being questioned, particularly by retailers operating in a tight market. Many retailers are now offering rental deals based on trading turnover.
The notion of rent being linked to turnover is not new. Turnover rents were popular in the retail sector in the 1980s and the early part of the 1990s, in a booming market. They lost favour to open market rents, with a conventional rent review at regular intervals.
Turnover rent structures
Landlords and tenants are introducing turnover rents as a means of helping both parties through these difficult times, whether through varying an existing lease or by granting a new one. Turnover provisions can be structured in various ways, the most common of which are as follows:
? The tenant pays the higher of a base rent and a specified percentage of its turnover.
? It pays a much lower base rent, which is then topped up by a specified percentage of turnover.
? It pays a base rent, which is topped up only if turnover reaches a specified threshold.
? The entire rent is based on turnover.
The advantage to the landlord of the first three structures is that it will receive a guaranteed level of rent, even if it falls below the market rent.
The last option is very risky and, depending on market conditions, can work either in the landlord’s or in the tenant’s favour.
Unsurprisingly, in today’s depressed market this method is rarely used.
Basic provisions
? Calculations of base rent and turnover percentage:
The base rent is normally based on a percentage of the open market rent, and will vary between 70-90%. The relevant turnover percentage will also need to be agreed. Factors such as the tenant’s identity, its business, the location of its premises, its turnover projections and the current market situation all play a part in establishing both figures.
If the lease term is for more than five years, the base rent is usually reviewed in the conventional way, but excluding the turnover provisions.
? Components of turnover: “Gross turnover” is defined as the aggregate of all sums for all goods sold. It should be inclusive and cover the entire business carried on at the premises.
The tenant’s business and methods of sale should also be considered. Nowadays, goods and services can be bought in a number of ways. The draftsman will have to consider whether buying through one of these methods affects the tenant’s sales figures. This must be done whether the tenant has one or a number of premises.
A key area is the sale of vouchers and gift cards. Where is the point of sale? When the voucher is bought or redeemed? Numerous factors have to be considered and provisions need to be tailored to each tenant.
Items to be excluded in the calculation of turnover are usually expressly stated. The most common are discounts and VAT or similar sales or excise taxes imposed on the tenant in respect of the supply of goods and services.
? Mechanics:
The turnover for each turnover period can be determined only at the end of the relevant period – usually one year. Most landlords are not happy to wait until then for the turnover rent to be paid in arrears. Hence, the tenant will usually pay a provisional sum for each turnover period (for example, equal to 80% of the turnover rent) at regular intervals, either quarterly or monthly depending on how the rent is payable.
At the end of the turnover period, the tenant will provide the landlord with a turnover certificate signed by a qualified accountant the tenant will prefer the certificate to be given by its in-house accountant. This is commonly required within an agreed time-frame, since the landlord will want to calculate and receive the turnover rent as soon as possible. Any underpayment will be due to the landlord on demand and any overpayment will usually be credited to the tenant.
The tenant must make available for the landlord’s inspection its accounts and any other supporting documents – vouchers, receipts, books and documents – for the purposes of ascertaining and verifying the turnover.
The landlord may also require such accounts to be audited by a qualified accountant. In addition to the turnover certificate, landlords like to be kept regularly informed of the trend in turnover.
Considerations
? Confidentiality:
Since their accounts constitute confidential business information, tenants will want to ensure that the landlord’s use of the data is for turnover rent calculations only. Confidentiality clauses are therefore common in turnover provisions.
? Keep open:
To ensure that the maximum amount of turnover is generated, keep-open clauses are normally included in turnover provisions. These are difficult to enforce and, in accordance with case law (Co-operative Insurance Society v Argyll Stores (Holdings) Ltd [1997] 97 EG 141), specific performance is unlikely to be granted as a remedy. Tenants will attempt to list various situations in which they are permitted to close premises.
The most common are closure resulting from damage from insured risks or to comply with statutes. When the tenant is temporarily in breach of these provisions, a deemed amount is used, calculated by reference to an average daily turnover. However, if the closure is more permanent, landlords will want to revert to open market rent.
? Alienation:
These provisions are more restrictive than those in an open-market-rent lease. Turnover provisions tend to be personal to the tenant and terminate on the assignment or underletting of the lease. The rent should then revert to the open-market-rent model. This is not surprising since the basis of any turnover rent negotiations will depend on who the tenant is and the nature of its business. The landlord will not want its income from turnover rent to be reliant on an unknown tenant or undertenant.
The good and the bad
? Advantages
Tenant default is not good for either party both seek to maximise income from the premises. Turnover rent offers tenants protection in difficult trading periods since the rent is not fixed, they may avoid the risk of insolvency. Landlords do not want vacant units nor do they want to be liable for rates and service charges, which would happen should a tenant default. They may even attract new tenants to vacant units if they are seen to offer flexible rent structures.
? Disadvantages
Landlords may face a reduced income flow because of their dependence on tenant trading. Rental flow may be erratic, perhaps leading to discounting. Valuing the centre or scheme may be difficult. Landlords may have to play a greater management role. Regular scrutiny of the tenant’s trading position is prudent including reviewing accounts and calculating each turnover rent.
Tenants will carry a greater administrative burden in terms of stamp duty land tax (SDLT). Since they will be unable to quantify the turnover rent until the end of the turnover period, the first SDLT return will be based on a reasonable estimate using turnover projections. It may have to file several returns, once the figures are known for the first five years of the term.
Most tenants will want to align the turnover provisions with the accounting year in so as to minimise the burden. The account date should, if possible, be the tenant’s year end.
Why this matters |
The economic climate has encouraged a more open dialogue between landlords and tenants. The income that landlords receive from centres and retail schemes rely on those premises being occupied by tenants that make regular rental payments, allowing landlords to service their facilities for those properties. Market conditions are ever-changing. Landlords and tenants have to accept that some form of restructuring may be necessary to enable the tenant’s business to survive and the landlord’s letting business to continue. Draftsmen have to be more creative in their thinking, but just as tight in their drafting. Terms have to be renegotiated to align them with new market conditions. By using leases that combine turnover rent and fixed rent, landlords may be able to maintain their preferred tenant mix and retain rental flows at acceptable levels. Initially, they may have to accept that rental levels will fall below previously agreed levels. Heads of terms may take longer to perfect. Each of the parties must determine the projected effect on its business at this stage. When the economy recovers, landlords may be in a better position to reap the benefits. Thus, any new deal has to have a good balance between the parties’ interests. This should mean that tenants will be paying an affordable rent, since it will turn on their performance and is likely to fluctuate depending on market conditions. It should also mean that tenants can concentrate on trading, instead of worrying about insolvency. Equally, it should give comfort to landlords, in that income flow will continue in the short and medium term. Turnover rents are likely to be in use for some time, even after the economy recovers, because of their flexibility. The Code for Leasing Business Premises in England and Wales 2007 encourages landlords to offer flexible leases and alternatives to the conventional open market rent review. It will be some time before turnover rent leases fall out of fashion. |
Further Reading |
Code for Leasing Business Premises in England and Wales 2007 Ross: Commercial Leases Bamford K, Bell T, Bruce A, Davenport H, Butterworths |
Karen Mason is a partner and Amanda Gray is a solicitor in the commercial property team at Boodle Hatfield
