by Bob Walsh
Turnover rents have received much favourable comment, yet, in spite of an extensive town-centre development programme in this country, very few centres have been let on turnover leases. This article examines the reasons for this and seeks to assess why both landlords and tenants are still reluctant to adopt this innovative and potentially mutually beneficial basis of rental assessment.
Capital & Counties have led the introduction of turnover rents in the UK and now a few other forward-looking developers are following their example. Lettings have recently been achieved in the St Ann’s Centre, Harrow, and the London Pavilion development at Piccadilly Circus on turn-over-related leases by Laing Properties/London Borough of Harrow and Grosvenor Square Properties/Kennedy Brookes, respectively. Phase two of the Sibec town-centre scheme in Birkenhead is also being let on turnover-related leases. With the odd exception of one or two retailers who refused to consider a turnover-related basis, surprisingly little difficulty was experienced in all three schemes in reaching agreement with the retailers.
Contrary to popular belief, the reluctance to introduce turnover leases probably lies mainly with landlords; yet, potentially, it is they who could derive most benefit from them.
Benefits to the landlord
The main financial advantage to the landlord is the prospect of achieving rental growth at annual intervals (assuming that the tenant’s turnover is increasing), as opposed to five-yearly intervals in the case of traditional leases, with nevertheless the benefit of a fairly high minimum base rental return. The landlord may well be able to achieve a higher level of income immediately if tenants have been over-cautious in estimating their turnover or if the landlord has managed to create a more successful scheme than market expectations.
Another significant financial advantage is that on a turnover-related basis the landlord can often avoid losing out on rental growth in the interval between the agreement of a preletting and the opening of the scheme, as this growth will be a reflection of improving retail sales.
The information obtained on individual tenant turnover also helps the landlord to manage more effectively, enabling him, for example, to understand more thoroughly the retailer’s business and performance and to spot weak tenants at an early stage. A turnover lease also usually gives him greater control on user and assignments. Given a regular enough system of monitoring turnover (currently lacking in most UK turnover leases) the landlord can swiftly assess the impact of promotions, changes in trading hours or any physical improvements to the scheme.
Active management is encouraged under the turnover lease system, with landlords able to obtain an immediate benefit following refurbishment works, rather than having to wait for reviews to fall due.
A side benefit of the turnover basis of rental assessment is the removal of the potential attitude of conflict between landlord and tenant, particularly at rent review when an 80% gearing arrangement makes negotiation potentially more academic and less contentious.
Given the substantial advantages, the reluctance of the vast majority of UK landlords to introduce turnover-related leases into their schemes is somewhat surprising. There are, however, certain disadvantages in going down the turnover route.
Disadvantages of turnover rents
Traditional turnover lease arrangements usually provide for base rents at around 80% of ERV and, as such, there is a risk to the landlord should turnover not live up to expectations, either in the short or the long term. Largely as a consequence of this, funds have only tended to value the base rents at a prime yield and have placed a greater yield on the higher-risk turnover income making up the other 20%, with any additional income being “top sliced” at money market rates. This often results in a lower capital value than that produced by the traditional rack rent basis and is a particular deterrent to developers seeking funding during the development period.
Some landlords also feel that weak or underperforming tenants are over-protected by the common 80% gearing arrangement in the turnover lease. This protection may be acceptable in certain cases, for example if it is in the interests of good tenant mix, but the “survival of the fittest” effect of market forces is nevertheless diluted. Landlord and tenant legislation in this country ensures that tenants are further protected, and although landlords would regard the removal of such security as desirable, British multiple retailers are generally more powerful than their US counterparts and are unlikely to surrender such security readily. They also tent to be more conscious of the value of property as a financial asset.
Landlords are also apprehensive of a system which puts them at a disadvantage in terms of knowledge and information with potential tenants who are obviously in a better position to estimate their own turnover. Most landlords will lack experience in dealing with turnover leases and will find it difficult to accumulate sufficient turnover information to enable them to make a reasoned judgment on the appropriate percentage level to be applied in each particular case.
In addition, calculation of the actual turnover rent to be paid is almost entirely dependent on returns provided by the tenants and consequently some landlords may consider the system open to abuse.
These are then some of the reasons why landlords have not let as many schemes on turnover leases as might have been expected. However, a more general explanation may be that they are reluctant to invest time in the initial learning curve. In addition, some are unwilling to adopt the more intensive management style required, both initially and throughout the life of the scheme.
Professional advisers, particularly lawyers and surveyors, are open to similar criticism. Many lawyers are still unfamiliar with the terms of a turnover lease and are reluctant to take on the task of redrafting their standard form of lease. Similarly, because so few schemes have been let on turnovers in this country, very few surveyors can advise authoritatively on the subject or speak with any experience. Their failure, however, to point out the advantages, or merely the alternative of adopting a turnover-related basis when appraising a shopping scheme must be considered a basic professional failing.
While there are additional safeguards that a landlord can employ to limit his downside, it must be appreciated that agreeing a turnover lease is a two-sided process and the tenant must also see some benefits from the system if his agreement is to be obtained.
The retailer’s view
The most obvious advantage to the retailer is the financial cushion created by virtue of the 80% base rent level which might come into play in the event of a downturn in trade resulting from general economic conditions, the scheme not coming up to expectations or a temporary aberration in his own performance. If the unit trades above expectations, more rent is payable but the tenant’s net benefit would also have increased.
The nature of the financial arrangements for turnover leases can lead to greater co-operation between the landlord and the tenant and will provide more areas of common interest and mutual benefit, not least of which is the mutual desire to increase the tenant’s turnover. Tenants should therefore welcome the more positive attitude and more pro-active management that will result from this arrangement. They will also welcome the removal of the attitude of conflict that often exists between landlord and tenant in traditional lease arrangements. After all, the arrangement is little different from in-store concessions that have been taken by multiple retailers within department stores for many years.
However, many UK retailers are reluctant to agree turnover-related leases, and some absolutely refuse to consider them. This reluctance to enter into turnover leases is largely due to the retailer’s belief that the success or failure of his unit within a scheme depends solely on his own efforts. He is unwilling to recognise the role that the landlord plays in his success. This attitude is understandable with reference to typical High Street locations and to some extent also in the case of many traditional UK shopping schemes where tenants have been left largely to fend for themselves. There is, however, a growing awareness that the developer/landlord has a very important role to play in ensuring the success of tenants in schemes. Tenants are, for example, dependent on landlords to instigate refurbishment at the appropriate time, to be responsible for the promotion of the scheme and to ensure an initial and continuing successful tenant mix. Most retailers are not yet convinced, however, that landlords in this country contribute sufficiently to centre management in terms of time, management expertise and expenditure.
Tenants are also apprehensive about releasing the necessary information on turnover to the landlords and fear that this information could fall into the hands of a competitor or even a potential predator. The mere task of providing turnover information is an unwelcome addition to the retailers’ workload.
Mutual benefits
On the whole both landlords and tenants can benefit from a turnover-related lease arrangement, particularly in today’s active development climate. They share the mutual aim of ensuring a scheme’s success in competition with not only the High Street and other major shopping schemes in neighbouring towns but also with second and third schemes in the same town or possible major out-of-town developments. It is largely the lack of experience and fear of the unknown shared by developers, fund managers and professional advisers that has been responsible for the lack of turnover-related lettings. The majority of the traditional shopping-centre owners and managers in this country remain ill-equipped to exploit fully such a financial arrangement to the advantage of both parties.
The investment institutions, in particular, tend to be traditionalists and would benefit by reviewing their “belt and braces” conservative attitude towards investment. They could benefit from expressing confidence in their own schemes by accepting a higher risk for higher rewards. The tradition of upward-only rent review clauses is inconsistent with investment in stocks and shares where dividends and capital prices are subject to significant downward as well as upward movements. With the right advice and management, risks can be kept to a minimum. In schemes with strong demand, initial base rents of close to 100% of traditional ERV can in fact be obtained, as Edward Erdman proved when letting both St Ann’s, Harrow, and the London Pavilion.
It must be accepted that the UK retail property market is unique and that a blueprint US-style system cannot be successfully implemented without a compromise that allows both landlord and tenant to see an advantage. Security of tenure provided by the landlord and tenant legislation in this country has been cited as one of the factors inhibiting the implementation of more turnover-related leases, but this runs contrary to experience in Scotland, where no such security exists. The Landlord and Tenant Acts provide sufficient grounds for obtaining possession at the end of leases for redevelopment or refurbishment and indeed it is possible to contract out of the provisions altogether. It is the strength of the UK multiple retailer that has ensured that their security has remained intact and that leases remain relatively long.
The future
In the immediate future I envisage a gradual increase in the number of schemes being let on turnover-related leases and the pace will gain momentum as awareness and knowledge of the turnover option grows and a more retailer-orientated pro-active centre manager emerges. Paradoxically, it is perhaps the stronger and the weaker schemes where turnover rents will be most used. In a strong scheme the landlord can impose near 100% base rents; in weaker schemes only a turnover-related basis with low base rent may attract the desired tenants. In the short term, the turnover rent system is most likely to be adopted by forward-looking developers building for investment rather than sale, particularly where they might have more confidence in the success of their scheme than the prospective tenants.
Landlords will give a higher priority to the active shopping-centre management and promotion than has previously been the case. Tenants will in turn work more closely with their landlord towards the common objective of ensuring the schemes’ immediate and future success.
In the longer term, I envisage that turnover-related lettings will become the norm rather than the exception, particularly in schemes funded through unitisation or securitisation. Despite VAT implications the average length of lease will come down to 10 years with an increase not only in the frequency of the base rent review but also in a regular review of the turnover percentage to ensure its relevance is maintained. A degree of tenancy security will remain, but landlords will ensure a greater degree of management control through more buy-back options.
With the increasing use of electronic point-of-sale equipment, landlords could be given far more frequent feedback on individual tenant turnover, which could be aggregated to ensure confidentiality. This could be used to measure the effectiveness of promotions or a change in trading hours, rather than being used merely to estimate next year’s rental income more quickly. Tenants will gradually appreciate the benefits of this approach and become less secretive about their own performance.
The surveyor’s role
The potential role for the surveyor in the turnover-leased shopping schemes of the future is a significant one, in terms of strategy, letting and centre management. However, surveyors could be found wanting in this more demanding role unless they can dramatically improve their research, information, experience and approach. Strong competition for the strategic role might well emerge from the retail analysts of stock-broking firms and retail management consultants. A more comprehensive, and therefor more serious, threat is likely to emerge from the increasing number of marketing and research companies — whose knowledge of some aspects of the retailer’s business methods and performance is currently superior.
Bob Walsh BSC ARICS is a partner of Edward Erdman.