Turnover rents: It all comes at a cost

Last year, as Covid-19 disruption began to impact bricks-and-mortar retail, the retail rental market saw a move towards turnover rents as a temporary, concessionary arrangement.Now we are seeing growing numbers of new retail leases granted on a turnover basis, and turnover rent arrangements imposed as part of retail tenant CVAs. But what does this mean for landlords, and how does this alternative rental structure affect the relationship with their debt lenders? What are turnover rents? Turnover rent arrangements involve the amount of rent payable by the tenant being calculated in whole or in part by reference to the turnover that the tenant achieves from the premises. The use of turnover rents creates a more direct and granular business relationship between a landlord and tenant, in which both parties to the lease have an interest in ensuring the success of the business operated from the premises. Where a tenant’s business produces a higher turnover, the landlord will receive a higher rent; conversely, where a tenant’s business is struggling, the tenant is not required to pay an unsustainable rent to the landlord. A turnover rent arrangement will usually reserve a basic rent of, for instance, 70% to 90% of the open market rent, or a guaranteed minimum that is reviewed periodically. Alternatively, the base rent may be tied to a percentage of the previous year’s net sales. In most CVAs in which the basis of calculating rents is moved to a turnover-based model, there is usually some proportion of “guaranteed base rent” provided to landlords. Turnover-only deals are not common in the UK. The All Saints CVA in June 2020 was one of the few CVAs that moved landlords to entirely variable turnover rents. What are the key concerns for tenants, landlords and debt lenders? The restructuring of a lease on to a turnover rent arrangement is not simple, and nor is negotiation of new, turnover-based lease terms. There is no one-size-fits-all solution. Made-to-measure: defining turnover A balance is required between what turnover is captured as rent, and what is actually affordable for a tenant, both in the current economic climate and once retail moves into a period of recovery. This is a key review and negotiation point as the landlord (and its lender) will want to maximise what is defined as turnover for the premises in question. This varies according to the type of retailer. For example, “showroom” stores whose primary function is to drive online sales (such as Nespresso or Apple) would need to adopt a different approach to more traditional stores whose products are primarily chosen and purchased on-site (such as most clothing retailers). It has become relatively standard to include store click-and-collect revenues in the calculation of turnover, but complexities arise in relation to orders made on an in-store iPad, for instance – especially if these orders are then fulfilled using stock from a central warehouse or another store. Tenants would argue that this should not count towards turnover. However, consider the landlord’s perspective: the order was only made at all because the purchaser visited that store. There are also complexities associated with store internet returns, gift cards, and special offers. Greater transparency While rack rent arrangements do not eliminate tenant business risk, turnover rents come with more unpredictability for landlord borrowers and their lenders. In turnover arrangements, borrower landlords have to conduct extensive investigations into the tenant’s economic business case before entering into the lease and any connected loan arrangements. This ensures the landlord is able to calculate the correct rent that it is owed, but is also likely to be a requirement imposed by lenders in loan documentation to ensure that they have a clear view of the revenue stream that will be used to service the debt. A potential area of tension is the level of ongoing transparency that landlords and, in turn, lenders expect from tenants in a turnover-based arrangement. A landlord will need to regularly assess its tenant’s turnover and verify the accuracy of its turnover reporting. Equally, its lender would expect to be granted sufficient rights to do so, and for these rights to be entrenched in the lease. However, successful tenants might not want to share information on turnover with their landlords or may not have the necessary data systems in place to share information in the way that a landlord or its lender prefers. Swings and roundabouts: downside protection and upside benefit In a turnover arrangement, lenders are taking the additional risk of underwriting turnover rents that may fall. Therefore some argue that this risk should be countered by any increased turnover rents being applied (at least in part) in prepayment of their debt. Some CVAs provide a prospect of sharing in the upside if the business improves as a result of the CVA. For instance, rental incomes could be topped up based on the performance of individual stores and, therefore, if turnover increases, the return to landlords improves. Additional financial covenants Lenders may seek additional financial covenants that address both the borrower’s and the tenant’s economic condition, beyond the typical loan-to-value and debt yield covenants. Such additional lender protections could include a rent cover threshold ratio, analysing the ratio of the tenant’s EBITDA to the total rental costs or, more simply, a creditworthiness test for the tenant. This test may be based on credit ratings (where available) or a net asset value test. Such financial covenant metrics would offer lenders a potential default trigger point in cases where earnings drop below acceptable levels. As is usual with financial covenants, these could also include relevant ratchets and cash traps, so that certain thresholds trigger cash traps only. Those trapped amounts would then be applied in prepayment of the loan if conditions do not improve. Just browsing: KPIs In addition to financial covenants, loan documentation may include key performance indicators. These are specifically crafted for each transaction, but inspiration can be drawn from hospitality sector metrics such as occupancy rates or average daily rates of revenue per room, or retail sector metrics such as footfall, recorded visits or even simply sales figures. Wherever trade volume and profitability can be measured, KPIs can be set. Landlords may also want to enshrine similar KPIs in their leases, linked to a break right whereby a chronically underperforming tenant can be removed in favour of a healthier alternative. Returns policy: reinstatement of rights Some CVAs include provisions that reinstate landlords’ rights to claim the full amount of rent due if the CVA fails. Where CVAs are used to move rental calculation to turnover-based models, there is also increased pressure from landlords for rents to revert to the previous contractual rates at the end of the CVA “rent concession period” (typically two to three years). The future of turnover rents When (as we expect) the government’s Covid-19 fiscal packages are withdrawn in the second half of 2021, and the moratorium on enforcement by landlords ends, it is likely that more high-street casualties will seek to restructure through the CVA procedure. However, there is increasing evidence that landlords are collaborating to push back on the use of aggressive landlord CVAs. This push-back may add weight to calls for reform coming from both the property industry and the insolvency and restructuring profession. High-profile challenges to CVA such as those made in the recent New Look case (Lazari Properties 2 Ltd and others v New Look Retailers Ltd and others – see “New Look landlords dispute ‘fundamental switch’ of rent arrangements”) could potentially slow or change the course of the trend of CVA-mandated turnover rents. In contrast, turnover rents agreed as part of an arm’s-length deal may hail the beginning of a new era of collaborative risk-sharing between landlords and tenants. This may ease the pressure on tenants from traditional rack-rented leases and contribute to the sustainable future of bricks-and-mortar retail. If this is the case, debt funders will need to expand their understanding of turnover rent arrangements and adopt forward-thinking practices to ensure that they can accommodate borrowers with these arrangements in place in their portfolios. It is likely, for example, that due diligence, credit approval and asset management processes will need to be updated, refined and expanded. This all comes at a cost; but whether lenders are able to pass that cost on to borrowers, or whether such infrastructure simply becomes the new price of a seat at the table, remains to be seen. European perspective Turnover rents are not a new concept in EMEA, though it seems that they have enjoyed a resurgence and renewed interest during the Covid-19 market disruption. Turnover-based rent arrangements were already common in jurisdictions such as the Czech Republic, France, Germany, Italy, Spain, and Sweden. There, turnover rents have traditionally been more evident in leases of larger retail premises such as in retail malls, and in leases of stores on sites such as outlet villages and airports. In some jurisdictions, turnover rents are market standard. For example, in Turkey retail mall leases are usually held on a turnover rent arrangement, regardless of store size, and turnover rents are also common for high street shops in areas with high footfall. In Russia, turnover rents are also very frequently used, again regardless of the area of the shop. Stefanie Price is a partner in real estate; Priyanka Usmani is a senior associate in restructuring and insolvency; Anthony Warner is a senior associate in banking and finance; Natalie Butchart is a knowledge lawyer in banking and finance; and Katherine Lang is a knowledge lawyer in real estate at Baker McKenzie Image © Pietro Recchia/SOPA Images/Shutterstock