Will Covid-19 lead to the return of the turnover lease?

Turnover leases have fallen in and out of favour with retailers and landlords as shopping habits change. However, given the increased pressure Covid-19 has placed on an already strained retail sector and with landlords looking to keep their premises occupied, there has been a resurgence of interest in the turnover lease model. When the lockdown was first announced, many landlords and tenants pragmatically agreed rent-free periods of between three and six months, together with the grant of an additional reversionary lease for at least the length of the rent-free period to ensure that the landlord was properly compensated. However, as stores begin to reopen, albeit with restrictions, the impact of Covid-19 may last longer than first expected. Even after it dissipates, it is likely to have a longer-term effect on consumer retail habits. Tenants want to pay less rent and landlords want to protect their revenues while keeping space occupied. A more collaborative future is likely to evolve and the turnover lease may be at its heart. How does it work? A turnover lease is, as the name suggests, a lease where the rent is calculated in accordance with the turnover generated by the tenant at the premises. Rent is not fixed, with the landlord’s rental income directly linked to the success of its tenant. Traditionally, a turnover lease mixed a fixed rent, often 80% of market rental value, with a top up rent of 20% based on turnover. They are often used with new businesses where cash flow is an issue for the tenant and for short-term or discount retailers. In calculating a turnover rent, the tenant will be obligated to provide monthly and quarterly turnover statements which the landlord will have the right to review and audit. In some instances, landlords may require daily reports with access to sales data. The need for retailers to keep sales figures up to date is paramount. Sticking points There have, however, been a number of issues historically with turnover rents – principally what comprises the turnover. The difficulty with recording online sales when many consumers use stores as showrooms with a “try before you buy” mentality has been a very real problem for the turnover model, leaving landlords feeling short-changed. Most retail tenants will have invested considerable amounts of money in sophisticated online retail offers and will, quite naturally, want to reap those rewards without having to share online revenues with their landlords. Landlords, however, will want any turnover lease to account for click and collect sales or returns made in store. These have often proven to be major sticking points. Seeds of change However, even before the outbreak of Covid-19 we were beginning to see signs of change on the high street, with reports of landlords taking equity stakes in retail tenants. Perhaps Covid-19 will accelerate even further the need for a greater collective desire for success. The turnover lease model fits seamlessly with this philosophy. We are already seeing a greater risk-and-reward relationship, with landlords and tenants agreeing turnover rents of up to a 50% split against the fixed rent. Turnover leases can lead to costly and time-consuming disputes if not worded carefully. A retail tenant may wish to include an upper limit or cap on the rent it pays and the landlord may wish to include a minimum limit or cap on the rent the tenant must pay. The landlord will also want to ensure that service costs – such as any seasonal marketing – are covered. With landlords potentially taking more equity stakes in tenants, a carefully worded lease should no longer leave tenants wanting to manipulate their turnover figures to reduce their rent and no longer leave landlords looking to maximise rents at all costs if it leads to greater returns through dividends. Landlords will naturally look to maximise returns for investors. This has traditionally been through high rents, but potentially the future is for a more cohesive and collaborative approach where the expertise of the landlord and its tenants are combined to ensure greater returns for everyone. In turn, landlords will need to take a greater interest in tenants’ business plans and accounts, and this may lead to more turnover leases being granted with longer terms, or at least “inside the 1954 Act” with a right to renew. The retail sector is innovative and so too are landlords. It is not outside of the realms of possibility for such a model to evolve on a store-by-store basis. There is also no reason why the turnover rent model should have to be limited to the principal rent payable under the lease. With the future of the retail market under such threat and with society’s desire to protect the high street, perhaps the calculation of business rates could also be based on a low base rate with an uplift on shop sales. This would greatly assist cash flow for tenants and lead to a much-needed modernisation and evolution of the retail market. Landlords and their agents could be well placed to carry out the auditing of such information on the local authority’s behalf. Dan McCarron is a senior associate in the real estate team at Collyer Bristow