by Hugo Hawkings
Fifty years ago the Luftwaffe blitzed Britain and German bombs rained down, ripping the heart out of many of our towns and cities. Inadvertently this destruction provided the catalyst for the present shopping-centre movement, giving major opportunities for reconstruction. Since then the shopping centre has evolved in ever-greater scale, from Coventry city centre through to the Metro Centre in Gateshead. Retailing, too, has changed beyond all recognition from small, locally based and often individually run businesses to the international conglomerates we have today. Laura Ashley, Body Shop and Marks & Spencer are familiar names from Singapore to San Francisco, and it could never be said with more justification that Britain is a “nation of shopkeepers”.
During this growth period the ownership of the bulk of UK retail property has been concentrated in the hands of relatively few institutions, today forming part of massive investment portfolios. Yet, during this era of increasing sophistication, our method of calculating the value of a trading position to a retailer has not changed: in this country market rent still predominates.
What is a shop, after all? Surely it is a method for a retailer to dispose of his wares to the public. This can clearly be seen in the food retail business, where the design of supermarkets and superstores has evolved to a fine art. Food retail businesses are clinical in their specification of new stores and will not accept any compromise. In such a high-turnover sector, convenience for customers is crucial. The same should apply to shopping centres. Yet what incentive is there for the landlord where rents are renewed on a five-yearly basis stemming from the concept of market rent, which may or may not reflect on the performance of the shopping centre? If the supermarket operator benefits directly from his expertise over and above his competitors, why do we not have shopping-centre operators?
One way to encourage a more proactive involvement in shopping centres is through turnover rents, whereby good landlords reap the benefit of their involvement and bad landlords suffer the effect of their neglect. Though virtually universally popular abroad, turnover rents have yet to penetrate significantly into the UK. Goddard & Smith and D J Freeman & Co jointly undertook a survey of leading retailers, property institutions, property investment companies and developers in the UK. The response showed 36% of retailers, but only 20% of the group of potential landlords, in favour of turnover rents.
The landlords’ main concern is the uncertainty of the turnover element of the income. A valuer confronted with turnover rent values the base rent at the prime yield and the turnover element at a risk yield, probably for the duration of the lease only. To date there has been an insufficient record of turnover-related rent to enable the valuer to be anything but conservative. A common response to our questionnaire was that turnover rents were not considered an alternative as they were “not acceptable” to the major financial institutions in this country. In the USA and France a greater experience of turnover rents enables the landlord to have more confidence in the income, and valuations are generally based on rents received.
There are now signs in the UK that turnover rents are becoming more widespread. A number of recent schemes have been let on this basis including the Pyramids in Birkenhead, the A1 Gallerias, Brunswick Pavilion, Scarborough, and London’s Canary Wharf. Capital & Counties — who pioneered turnover rents in this country — have continued to let their centres in this way.
As turnover rents become used more often valuers will have greater evidence on which to base their valuations. Equally, they will become more familiar with the concept. This should mean that their valuations of turnover rent schemes will be less conservative, and instead of being down-valued, as they are now, they will become fully recognised and valued as a means for an investor to participate, immediately, in the success of the shopping centre.
Turnover rents are not suitable for every situation: much depends on the quality and location of the centre and on the individual scheme. One attitude to turnover rents was that their use should be dependent on tenant demand and, where it is high, turnover rents and short-term lettings would be attractive.
However, it was the retail response that we found most surprising. Retailers were concerned that, with base rents in the UK generally at 80% of market rent, the turnover element would represent “the icing on the cake” for landlords, rather than create a genuine “partnership”. Significantly, over 60% felt that the base rent should be 50% or less, whereas much greater variations in the base rent exist abroad. If turnover rents are to create a true partnership the percentage of base rent needs to be reduced.
The structure of turnover rent leases was also a major concern. To maximise the potential of turnover rents the leases should be contracted out of the Landlord and Tenant Act 1954 in order to avoid security of tenure and allow active control of tenant mix. Ideally the lease should be short in duration (five to 15 years); since the Finance Act 1989 it is no longer necessary to grant commercial leases over 21 years in order to recover VAT. This, with the prohibitions within the lease against change of use and assignment, which are important with turnover rents, restrict the value of a tenant’s leasehold interest.
This inability for a retailer to build equity within a scheme can have an adverse impact on the viability of the unit. In the current market, however, with a surplus of available shop units and with rent reviews based on historic rental growth, the leasehold interest may now be seen by many retailers as a liability.
We found from our survey that a number of retailers were concerned about not recovering the full cost of fitting out their unit if leases were shorter. However, 80% of retailers sought to write off their fitting-out costs over a period of 10 years or less. Significantly, 70% of the group of landlords were prepared to provide shops with higher than shell specification for short leases.
As well as highlighting the major concerns relating to turnover rents several positive aspects were identified. Clear majorities of both retailers (57%) and landlords (66%) felt that turnover rents improved the relationship between landlord and tenant. The most significant advantage must be the creation of this partnership with the common aim of promoting the shopping centre. Currently rent-review and service-charge negotiations often prove instrusive and produce a negative atmosphere. A turnover-based element of the rent will mean that it will reflect, to a certain degree, the conditions under which the tenant trades. Where the base rent is index-linked, as in some instances in France, these negative aspects can be done away with.
In our survey, 73% of landlords preferred leases of 15 years’ duration or less in shopping centres. At the same time 86% recognised that most shopping centres will require refurbishment within 15 years at the most. There is clearly an awareness among landlords of the relationship between lease terms and the refurbishment period. One of the more significant problems of obsolescence is that of obtaining vacant possession to enable redevelopment to be undertaken. Where leases of 25 years have been granted this can prove expensive and sometimes impossible, and lengthy negotiations will be required.
Turnover rent leases provide the incentive for landlords to upgrade their centres continually as they will benefit from the moment the refurbishment is complete instead of having to wait for the rent review pattern to fall due.
The creation of the right tenant mix is vital to shopping centres, with 90% of landlords advocating greater control. Turnover rent leases enable the landlord to undertake this role, with greater information available on tenants’ performance. Shorter leases, outside the Landlord and Tenant Act 1954, allow the landlord to replace weaker tenants and give them greater freedom to experiment with independent and new retailers (without having to be committed to 25-year leases) in addition to being able to monitor their progress.
In the Goddard & Smith/D J Freeman & Co survey the lack of support by retailers for turnover rents indicated serious reservations. However, a more detailed analysis of the results shows that this resistance is based on the current arrangements for the turnover lease in the UK. A reduction in the current prevailing base rate (80% of market rent) would create a far more positive response.
Clearly what is required is a change in shopping-centre philosophy from both retailers and landlords. Shopping centres are a business in their own right and require a more flexible approach: there were encouraging signs from the results of the survey that both sides acknowledged and accepted this. In the future, we may see shopping centres run as businesses with the centre manager as the managing director. Perhaps we will have shopping-centre operators in much the same way that we have supermarket operators today — who will be the “J Sainsbury” of the shopping-centre business?
