Clause for thought – getting turnover rents right

In part four of EG’s series on clauses in commercial leases, Tim Burbidge and Sarah Foden shine a light on turnover rents. During the pandemic much has been written about turnover rents being the future of retail, but they have been used in the UK since at least the 1980s and their popularity grew in the recession at the beginning of the 1990s. Turnover rents have evolved to keep up with changing times and today they often play a key role in securing a letting in the retail, leisure and hospitality sectors. What is a turnover rent? Put simply, it gives the landlord a fixed percentage of the tenant’s turnover rather than a fixed rent. For a long time, the standard turnover rent arrangement involved a discount to the headline market rent with a top-up turnover. The tenant would pay the higher of 75-85% of the market rent and a percentage of the tenant’s turnover, normally between 4% and 12%. The actual percentage would depend on the tenant’s business, so a low-volume/high-margin business commanded a higher percentage than a high-volume/low-margin one. In this traditional turnover scenario, if the landlord considers the market rent to be £100,000 and the agreed turnover percentage is 5% then the tenant would pay the higher of £75,000 and 5% of their total turnover. If their turnover was less than £1.5m a year then no turnover rent would be payable. If it was more the tenant would pay a top-up equal to the difference between the base rent and 5% of turnover. The advantage of this system is that there is always a market rent sitting behind the turnover, so if for whatever reason the turnover rent becomes inappropriate (for instance the tenant closes or assigns its lease) then the parties can revert to a market rent. They also have a base on which to undertake a rent review. What makes turnover rents difficult? Leaving aside the valuation challenges, it is not always easy to agree what the tenant’s turnover is. While there are some obvious exclusions (for instance the turnover must be net of any VAT and take into account any discounts – although there is debate about whether that includes staff discounts) some areas can be problematic. For instance, do you count a gift card when it is sold or when it is redeemed? It clearly shouldn’t be both. Online retail has also created further challenges. How do you deal with click and collect? It is usually treated as an online sale, but customers are only going to buy something over click and collect if they can visit a physical store to pick it up, so why shouldn’t it be included in the turnover calculations? Some retailers charge a fee for click and collect. Should that be part of turnover? And what if we are calculating turnover for a restaurant or takeaway? Should that turnover be net of the fees charged by the home delivery companies? For that matter, shouldn’t we be deducting any customer returns? Fortunately, there are standard lists which any experienced retail tenant’s or landlord’s solicitor will have to hand when negotiating turnover provisions in a lease. In contrast to a fixed rent paid in advance, turnover rents necessarily have to be paid in arrears. This delay in receiving rent can be addressed by having a ratchet mechanism so the tenant pays the higher of the market rent and the aggregate of the market rent and the turnover rent paid in the previous year (or highest amount paid in any previous year). It can be a proportion of that figure or an average of previous years, so tenants are not penalised for exceptionally good trading years. Pure turnover – tricky points The challenges of the current climate have led to the growth of a different type of turnover rent – pure turnover. In this scenario, there is no market rent and the tenant pays only a turnover rent. This mechanism too has been around for more than 30 years, but it only really becomes prominent in times of market difficulty. With no base rent payable at the beginning of the lease term, the likely rent payable can only be based on predictions of what the tenant’s turnover might be. Nonetheless, it has become a very popular form of turnover, featuring in the recent CVAs for New Look and Pizza Hut. So what additional issues need to be considered if a pure turnover model is adopted and the absence of a market rent removes the anchor point in the life cycle of a typical lease? As a rent payable in arrears, how do you calculate any rent payable before the landlord has any turnover figures to use? Should the tenant be given a rent-free period until turnover information is available? How frequently should the tenant pay turnover? If turnover rent is payable based on quarterly or even monthly figures, this will lead to significant fluctuation; November and December could be excellent months but trading in August (a popular holiday month) may not be so good. If provisional rent is payable, there will need to be an annual reconciliation to balance this out. Once a benchmark for turnover has been established, it will be possible to have a provisional turnover rent figure with a reconciliation at the end of the year. This approach may help smooth out seasonal trading patterns. What happens if the tenant closes down or temporarily stops trading? There is no longer a deemed market rent for any periods of closure. Should there be provisions to allow the lease to revert to a “market” rent, for instance on assignment? This is easier to agree if this is a renewal of an existing rack rented lease. If there is no backstop market rent, there can be no rent reviews. What happens if the tenant wants to assign the lease? If the tenant is allowed to assign the lease to an entity that operates a different business, the turnover rents received by the landlord may be very different to what was originally envisaged at the start of the lease. A better option may be to prohibit alienation but give the tenant regular break rights throughout the term of the lease. Tenant’s break rights are often conditional on the tenant being up to date with its rent payments, which is a powerful incentive that ensures the landlord is not left with unpaid arrears. As turnover rent is paid in arrears, there will have to be a reconciliation after the break date and, if necessary, the landlord will need to rely on well-drafted provisions in the lease to enforce a final rent payment following the end of the lease term. A landlord may favour shorter-term leases as it will not want to be stuck with an underperforming tenant for an extended period of time. For this reason, pure turnover leases should be contracted out of the Landlord and Tenant Act 1954, be granted for a shorter term and/or have not just tenant-only breaks but landlord break options too that are exercisable if the tenant’s turnover does not reach a certain threshold. Summary Key points to think about when agreeing terms for a turnover lease: Is it a pure turnover lease or a top-up turnover? What rent will be paid for the initial period when the turnover is unknown, or will there be an extended rent-free period? Could there be a provisional rent based on historical turnover until the current year’s turnover has been calculated? How frequently should the turnover be calculated and then paid? Are there any key exclusions/inclusions on calculating turnover, for example click and collect orders? This may depend on the specific premises or the tenant’s trading model. What if the tenant fails to achieve the anticipated turnover? Should there be a mutual right to terminate? Should there be a cap on the maximum rent payable? What happens if the tenant assigns or underlets, or should the lease be a flexible, non-assignable lease? What happens if the tenant closes for trade? Should there be a distinction between, say, early closing each day and a full non-trading day? Will the tenant be expected to trade seven days a week? Exploring these points before instructing solicitors will benefit everyone. It will ensure the agreed lease protects the position of both landlord and tenant in a trading environment that may well need to flex as we learn to live with the pandemic – a win for all parties. Tim Burbidge is a partner and Sarah Foden is an associate in Womble Bond Dickinson’s real estate business group Photo © Oliver Dixon/Shutterstock