Leases
Linking rent to turnover can be an attractive option for hard-to-let retail
properties, but make sure the difficulties don’t outweigh the benefits, writes Jane Turley
Turnover rent leases emerged in the recessionary conditions blighting the USA in the early 1930s and first came to prominence in the UK during the challenging years of the early 1990s. Adopted now in China, apparently in response to falling spending and likely over-supply in the shopping centre sector, it is tempting to think that, as the UK struggles to climb out of recession, a turnover rent lease will always be the right option if retail premises prove hard to let. But is this really the case?
Click and collect
A lot has been written in the past few years about the challenges presented in this area by changing shopping patterns; mainly the effect on turnover in retail outlets of the ever increasing level of internet sales. More attention is now, rightly, being focused on how internet sales and returns are accounted for in the calculation of turnover for the purpose of assessing annual turnover rents. If internet returns are accounted for but internet sales are not, this can create a serious imbalance – suggesting that this is something that should be addressed as part of the negotiations and recorded in heads of terms. To analyse the issues adequately requires a deeper understanding of the tenant’s business than in the case of a rack rented lease.
Pros
There are undoubted benefits associated with turnover rent leases: at their core, they differ from rack rent leases because the rent ultimately payable by the tenant is not set at a fixed level but is linked to the tenant’s turnover at the premises. This feature, in theory at least, means that the interests of the landlord and tenant are aligned: the more trade the tenant does, the more rent it will pay. This should incentivise both landlords and tenants to work hard to maximise the tenant’s turnover. Equally the turnover rent lease format enables risk to be shared between landlords and tenants.
Cons
There are also a number of perceived disadvantages: these include retailers often being uncomfortable with the underlying concept that this type of lease requires disclosure of turnover information on a frequent basis. Landlords are reliant on accurate and regular figures both to calculate rent and assess the impact of promotions and changes in tenant mix on a store let on turnover terms. Is the material provided correct and does it reflect the requirements of the lease? Careful analysis of the data can consume valuable management time.
Despite the difficulties accompanying internet shopping and other perceived disadvantages, the general consensus appears to be that the turnover rent model is here to stay.
How they work
In his article on 1 June 2013 (p82), Anthony Tanney described the two most common forms of turnover rent lease: the first, which is often referred to as a “turnover rent only” lease, where there is an “on account” payment made by the tenant but the final rent has no minimum level; and the second, which incorporates a minimum (base) rent, plus a potential turnover top-up if a pre-agreed turnover level is achieved. Which of the two forms is appropriate to a particular letting needs to be carefully thought through.
Although it may go without saying, assessing predicted turnover accurately at the start of the lease and setting an appropriate percentage of turnover to be paid is critical to both the principal forms of turnover rent lease. This requires a good understanding of the particular sector of the retail market the prospective tenant operates in (because gross margins vary between different sectors) and of the pitch being offered to them.
There are other variations commonly seen in practice: to address the concern that the eventual rent payable may be too high or too low, caps and/or collars are used, so that, for example, the rent payable cannot fall below the rent payable in the preceding year or, cannot be set above a pre agreed maximum level.
Stepped percentages applied to different levels of turnover achieved is another variation often employed.
Complications
These common features of turnover rent terms begin to suggest there are a number of possible pitfalls for the unwary. Consider the following examples:
First there are several key areas where careful thought needs to be given in order to tailor the specific form of turnover lease to the precise circumstances of each letting. Will there be a “base rent” in the sense of a guaranteed minimum amount payable in all circumstances? Or by “base rent” do the heads of terms really refer to an on account payment made by the tenant until the final rent is determined, when there will potentially be a refund paid as a result of the deal being “turnover only”?
If these key issues are not addressed at the heads of terms stage, they may (or may not) be picked up on later by the lawyers when the detailed terms of the lease are under negotiation, but they may then fail to be given the prominence they deserve.
Secondly, the interaction of rent commencement dates, rent free periods and turnover rent calculation dates can give rise to significant management headaches: traditionally retailers are assumed to prefer the turnover rent calculation period to be in line with their financial year end – but this is unlikely to coincide with the start of the lease, or the end of any rent free period. This can mean that complicated drafting is needed to articulate what the heads of terms require. This can in turn lead to misunderstandings and conflict when calculations of turnover rent are produced.
The right way forward?
The popularity of turnover rent leases continues, despite the complications presented by internet shopping. They have become more sophisticated over time to meet the challenges of changing circumstances and requirements. However, it is this very sophistication that informs the answer to the question whether this form of lease is always the right solution.
The work required to get the terms of a turnover deal right and the possibility of problems and management headaches must surely dictate that the potential reward (whether measured in cash terms or more generally, such as retaining a struggling retailer – Republic being a recent example) must outweigh the cost. Typically, for lower value rents, the probable advantages of this form of lease are likely to be outweighed by the difficulties that may arise.
Jane Turley is a managing associate in the real estate dispute resolution team at Nabarro LLP