As the UK retail and F&B property sectors increasingly embrace turnover-based leases to help both landlords and occupiers meet the challenges of current market conditions, Alison Key looks at the potential and pitfalls of this type of lease structure.
Turnover leases can play an important role in transitioning the leasing of retail and F&B property to a new basis. However, they require a wholly different approach to quantifying the rent due and the structure of the lease and also to the relationship between landlord and tenant.
Traditionally, setting rents for retail and F&B property was a fairly binary process. A matrix of comparable rents and the prevailing level of occupier demand predominantly set the tone for what a landlord would quote - and then the negotiations would begin. There were, of course, some rental calculation particularities – most notably Zone A retail rents – but the ‘give and take’ of negotiations would usually centre around not only the headline rent but other bargaining chips such as rent-free periods and capital contributions to fit-outs. This was because the landlord would invariably want to preserve the best rental tone to influence subsequent lettings and also support the ultimate investment value of the property in question.
In contrast, basing rents on an occupier’s turnover requires, by definition, a case-by-case approach. As such, it demands a more forensic method of structuring a lease. When looking at how to structure genuine, turnover-based leases which are workable in the long-term, there are also needs to be a distinction drawn with many of the kind of fire-fighting arrangements that have been made during recent months. A large proportion of these could only be described as being ‘turnover-based’ in that they involved a relatively basic calculation of what an occupier could afford in the face of continued market and economic disruption. Many also will not include a base rent which we believe is ultimately essential for asset owners and the valuation process. As the world situation changes and trading normalises, the temporary arrangements of the past year will need to be revisited and reshaped.
In the meantime, for landlords who are looking to make turnover provisions a more long-term, appropriate and equitable part of their leasing strategy there are various key points they need to address.
What’s in and what’s out?
The most important factor in agreeing a genuine turnover-based lease is determining exactly what aspects of an occupier’s revenue is captured in the agreed scope of ‘turnover’. Occupiers need to be very clear about the basis of their turnover projections and what that encompasses. If there are exclusions, they need to be explicit at the outset.
For example, is click-and-collect trade included or should turnover only be applied to sales of stock that have been held at the store? All parties are feeling their way at the moment and most landlords and occupiers are not used to sharing data. As a landlord, if you don’t have historic turnover data then it’s difficult to evaluate what is being projected from a standing start.
In this respect, affordability modelling will become increasingly important as that will bring perspective from beyond the specific property and occupier in question. It will be able to project what that type of retail or F&B operation could be expected to generate in that location from a unit of that size and with the prevailing footfall. The rather anecdotal understanding that, for example, a watch or perfume store is more likely to turnover more than a children’s shoe shop or health foodstore now needs to be supplemented with more granular data.
Here’s one I made earlier...
Of course, there has been a very successful, long-term model for applying turnover rents to retail and F&B environments: the UK outlet centre sector. For many years, some landlords have used advanced techniques for monitoring turnover allied with active management to lease their centres.
On the basis of leases outside of the 1954 Act this has enabled them to provide a flexible deal for occupiers but also allows them the latitude to part company with retailers/F&B operators who are not generating sufficient revenue. The quid pro quo, of course, is that the occupiers have a bespoke arrangement and also more landlord interaction to support them.
It is an approach based on assiduous data collection and also demonstrating to occupiers how landlords can respond to the rhythm of trading and support it with initiatives such as events and targeted marketing. To some extent this has also been deployed in the mainstream shopping centre sector but without the same focus on turnover and the factors that influence it.
The kind of model that has been pioneered in outlet centres depends on collaboration, transparency and trust.
Mutual benefits
Unfortunately, even before the pandemic hit, the general market conditions in the retail and F&B sectors were not, in many instances, leading to very positive relationships between landlords and occupiers. The pandemic has only served to exacerbate that as everyone has struggled to reorientate their businesses. So one of the main challenges is to improve those relationships.
The only way to get these turnover leases to really work well is when you have a relationship which means that everybody’s getting something out of it and both parties trust each other. In addition, adequate checks and balances can be put in place and, of course, affordability modelling and a building a data series means that it’s relatively straightforward to spot anomalies.
Certainly, the experience of outlet centres is that there is very little predisposition to misrepresentation and it is easy to pick this up in the very rare instances when it happens. In this respect, building comprehensive data sets is key. Also, occupiers should be required to produce audited accounts relating to revenue so this is a substantial safeguard in terms of monitoring the veracity of turnover figures.
Why did you bring your lawyer?
Our main role as legal advisors in this area is, as ever, to protect the client’s interest. As turnover-based leases evolve and because of the clients we work with, DAC Beachcroft has gained a deep knowledge of where the potential benefits lie for turnover leases and where the pitfalls are.
In the current situation, the most common piece of advice has been not to sign-up to anything which has a term longer than next summer. Switching to a turnover agreement with no base rent has been expedient in many cases but it is not sustainable or desirable.
Certainly, one of the next priorities for landlords who have had to go down this route will be to implement base rents - but not ones which are too ‘full’ as that can be as prejudicial to their interests as ones that are too low. As the current widespread over-renting of properties illustrates, rents need to be appropriate and sustainable if voids are to be minimised and a continuity of income maintained.
We can advise on making provision for how base rents can be set and reviewed and on issues such as alienation and the relationship with online trading. For example, if your tenant has carved out of the agreed turnover calculation the contribution that a store makes to generating online sales, and then devotes their entire shop window to a sign that says ‘Buy on our website and get 20% off’ what is your recourse?
New learnings for a new market
With turnover leases the devil is in the detail. There is a learning curve to be gone through, but if you can leverage the past experience of others who have applied a turnover approach, and protect your interests through a fit-for-purpose legal structure then turnover-based leases can provide a highly flexible and equitable way forward for both landlords and occupiers.
