What are turnover rents and why have they not become more widespread in the United Kingdom?
The principle of turnover-based rents is not a new one, although they will often be referred to as royalty rents, percentage leases or equity sharing rents. Turnover-based rents have in fact been with us for some years, even in the UK. Leases of petrol-filling stations, where the petrol throughput is an important rental determinant, and royalties paid for mineral extraction are both examples of turnover rents. There are also other isolated cases where for particular reasons comparable evidence is not available — the letting of kiosks at transport terminals for example. Turnover-based rents are also commonly paid by concession-holders in department stores. However, the appearance of turnover rents in the more general context of High Street retailing has been limited to date, notwithstanding the pioneering efforts of developers such as Capital & Counties in major schemes like Eldon Square, Newcastle, and the Ridings in Wakefield. More recently, Burton Property Trust have introduced turnover rents at their Brunswick Pavilion centre in Scarborough. These though, notable as they are, tend to be the exceptions.
History
As with so many retail innovations, turnover rents first became established in the United States. During the 1930s recession consumer expenditure was badly hit. There was an over-provision of retail space and few retailers were prepared to commit themselves. Landlords who were unable to let shops and were, therefore, threatened with bankruptcy saw the adoption of turnover rents as a potential solution. Offering a lease with a rent based on trade volume would have the attraction of not burdening tenants with substantial overheads at the commencement of the lease and would allow them to build up trade gradually. From the landlords’ point of view it was better to let the shops, albeit at a reduced initial rent, rather than not let the property at all.
With dramatic increases in car ownership during the 1940s and 1950s and the development of suburban shopping centres, the adoption of turnover rents increased. They also avoided the difficulties of setting rents in the new out-of-town locations where there was no established body of comparable evidence.
Tempting as it is to make the comparison, the present retail recession is very different from the depression of the 1930s. Even so it has been argued that the difficulties now faced by retailers might encourage more landlords to adopt turnover-based rents.
There has always been a reluctance to embrace this form of rental calculation. When faced with the problem of retail warehouse rental calculation, a new retail form in a new retail location, the problem of lack of market evidence was addressed by applying an uplift to basic warehouse rents rather than by having regard to turnover which might have been more logical, and indeed more profitable. There are, however, some signs that attitudes are changing.
Mechanics of turnover rents
Turnover rents are based on applying a percentage figure to the retailer’s gross turnover, subject to certain deductions. This is less troublesome than a calculation based on gross profit and is less open to abuse by manipulation of gross profit figures. The need for a regular turnover statement from the tenant is written into the lease, which will also specify details of accounting methods. Most leases will require provisions for the submission of a turnover certificate from the tenant’s accountant, subject, in some cases, to the scrutiny of independent auditors.
Normally the gross turnover calculation is subject to certain deductions for items such as VAT, sales to staff members and returned goods, and even specific deductions where the sale of certain goods is subject to high rates of tax or where a high proportion of the sales is by credit card to make allowance for the percentage charged by the credit card companies.
Once the turnover figure is known the main determinant of the actual rent is the percentage to be applied. This figure will be negotiated at the outset and will be based on the profit margins normally expected for the particular trade concerned. In the US such percentages are regularly published to provide guidelines for negotiations between landlord and tenant, and even in this country there is now some information on the appropriate percentages for particular trades. Different trades produce widely varying percentage figures, from less than 1% up to 15%. Large space users will tend to pay lower percentages and a typical range of percentages might be:
Broadly speaking the high-volume traders tend to work on lower profit margins and vice versa, thus tending to equalise rents despite these wide variations in percentage rate. Once agreed, the percentage figure will remain fixed for the duration of the lease, but it may be advisable to draft a review of this rate into the lease to take account of long-term changes in profitability.
Clearly the benefit to the tenant is the guarantee that a poor trading performance will be balanced by lower rental payments, but this is offset to some extent by the tendency to agree a minimum base rent to protect the position of the landlord during periods of poor trading performance. The level of the base rent is of course negotiable, but experience indicates a level of around 75% of the full market rental value and, like market rents, the base rent will be subject to regular reviews. The base rent at Burton’s Scarborough scheme is 80%.
The base rent is not a necessary feature of the turnover lease, but it is likely to be required to enable a development to receive funding from major investing institutions. The existence of unrealistically high base rent levels has been identified as one of a number of reasons for the slow take-up of turnover leases in this country when compared with the United States and Europe(1).
It is, of course, difficult to ascertain turnover in advance, so there is a tendency for the turnover element to be payable in arrears with the base rent payable in advance.
Legal considerations
The turnover lease requires a markedly different structure to the conventional lease and this may be one reason for its slow take-up in the UK. Particular clauses which require attention include the rental provisions, user and alienation clauses.
In addition, performance clauses may be included, bringing the system into direct conflict with the traditional pattern in this country.
As with standard market rent leases, the objective is to ensure a reasonable balance between landlord and tenant. The user must be clearly defined, restricting both the type of business to be carried out from the premises and even specifying the goods which can be sold. This ensures that a lease cannot be assigned to a trader dealing in goods which would otherwise be subject to a higher percentage of turnover. However, an absolute bar on change of use may discourage potential tenants so it is more usual to arrange to fix a new percentage every time there is a change of occupier. In some cases the lease will stipulate that a new user will revert to a full rack rent for a period of about a year, after which a new percentage figure can be fixed, based on the actual turnover of the new occupier.
Similarly, subletting clauses need to be drafted to ensure that the landlord will share in the benefit of a subletting to a user with a higher turnover, so that the lessee does not revert to the base rent simply because he himself is not trading. The rental benefit must therefore be based directly on the actual trade from the unit itself.
Rent reviews will remain important where there is a base rent and this is subject to review. The fact that the base rent may well be fixed as a percentage of the market rent and in successful trading conditions will represent only a proportion of the total rent payable should, however, make it a less critical factor than in conventional leases. If a review of the percentage figure is included this will be more controversial. However, the reviews of the percentage will not occur so frequently as conventional rent reviews, because its main function will be to take account of unforeseen changes of circumstance such as long-term fluctuations in profitability or changes of use.
Performance clauses are a common feature in turnover leases. These will specify a minimum sales volume, and failure to meet this target may result in the termination of the lease. This would enable a landlord to replace poor performers, thus enhancing the long-term success of the scheme. In a sense this is logical from both points of view, as the poor performer would probably have no wish to continue trading. However, in this country the commercial tenant is protected by the Landlord and Tenant Act 1954. It will be necessary therefore for the landlord and tenant to make a joint application to contract out of the Act under section 38(4). The Act preceded any widespread use of turnover rents in this country and it could be argued that the law should be amended in this respect. The essential fact is that a fair balance between landlord and tenant should lead to a more amiable relationship and one which is to the mutual benefit of both parties.
Advantages of turnover leases
Standard retail leases will normally be based on five-yearly review patterns. Consequently, tenants will enjoy periods of profit rent between reviews where rental values are rising. The landlord is therefore unable to share in this windfall. Under the turnover system if inflation increases the cost of goods sold the landlord will benefit automatically with what will be an inflation-proof rent. Initial rental payments may well be lower than market value, but this will be compensated by regular rental growth. Prelets in new locations can be negotiated well in advance of completion without fear of losing out if rents grow in the interim.
Retailers on the other hand may feel that any benefits from increased trade are due to their own efforts and that they should benefit from the rewards. But in reality the success of a trading unit in a modern shopping centre is also due to the efforts of the landlord in terms of general promotion and management of the centre. Both parties have a vested interest in the success of the centre, and turnover rents do seem to emphasise the concept of partnership which is central to good estate management.
Rent review negotiations should become less protracted, as it will not be so essential for the landlord to extract every last penny out of the tenant when the base rent is fixed, because if this is low the benefit will automatically accrue in the form of increased turnover.
Tenants should be able to plan long term, as they should know what proportion of turnover will be payable as rent, rather than face dramatic fluctuations which can occur with the traditional review pattern. It should also enable retailers to cope with the inevitable low turnovers which occur during the period when the business is being built up. This is particularly reassuring with new ventures or new locations. Tenants will have the advantage of knowing that they will pay less rent during periods of poor trading. This occurred in the Ridings Centre in Wakefield during the miners’ strike, when the landlords were prepared to accept a lower rent in the short term in response to a specific change in circumstances.
Turnover rents make it easier for landlords to achieve the right tenant mix because it will be possible to let similar units to different traders at varying rents rather than letting all units to the highest bidder. Tenant mix is of course crucial for the long-term success of a scheme.
Under a turnover lease the landlord will have a direct interest in the volume of sales achieved by the tenant. This will tend to lead to a closer involvement with the business, bringing both landlord and tenant into partnership. This can result in joint promotions and advertising and a very much more active style of management. Turnover information will enable landlords to be better informed about the performance of the tenants individually and as a whole, so that policy changes and promotion can be monitored more closely. The effect of a change in opening hours, for example, could be identified more quickly and with greater precision if regular turnover information were available.
In view of this seemingly impressive list of advantages one can be forgiven for asking why it is that turnover rents have not been more widely adopted. There are, of course, disadvantages. In this country the Landlord and Tenant Act 1954 provides security to the tenant, who will therefore be confident in undertaking expenditure such as fitting-out, secure in the knowledge that this can be spread over the term of the lease. With the more limited degree of security implied under a turnover lease the landlord would normally be expected to pay for most of the costs of fitting-out, although this does not seem to have held back those schemes where turnover rents have been implemented.
Tenants may be reluctant to reveal their turnover for fear that the information will be useful to competitors. But there is also a degree of inertia. Landlords inexperienced in turnover leases may be at an initial disadvantage in negotiations with retailers, who will obviously have a great deal of information about their own potential. Developers are also reluctant to accept low initial returns and the funding institutions the uncertainty of rents which vary from year to year. If the initial rents in a new scheme are expected to be below market ones this could hamper the ability of the developer to sell on to a financial institution. There is a tendency to value schemes let on this basis by applying a normal risk rate to the base rent, which is guaranteed, but a higher rate to the less secure turnover element. Inevitably this cautious approach will produce a lower valuation than a conventional market rent basis, making the turnover scheme look relatively unattractive as an investment.
Many financial institutions are sceptical about funding centres leased on turnover rents and those who are prepared to do so tend to look only at developers with a proven track record. However, in the present stagnant retail market it may be time to experiment with an alternative system, and if institutions are prepared to accept higher risks in return for a potentially higher reward the system could find more widespread acceptance.
(1) The Shopping Centre Business. Report by D J Freeman & Co and Goddard & Smith 1990, (see Estates Gazette July 14 1990, p2).
