Are turnover rents a solution to the fixed rents problem? | Deloitte UK has been saved
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Historically, commercial rents in the UK have been fixed annual commitments across a defined lease period. Rent-review clauses typically specify the rent to be appraised every five years, and that it can only increase—so called ‘upward-only rent reviews’, although these clauses have had less and less relevance in recent years as the extent of over-renting has become more apparent.
Retail landlords and tenants have typically agreed rents by reference to the prevailing ‘tone’ i.e. allowing the highest rent paid in a given location set the price for any other space available in that location – regardless of the retail use (and margins) that space might ultimately be used for. The agreed ‘tone’ has, in turn, set the evidence base against which rent reviews, lease renewals and, indeed, business rates are set.
The problem with ‘tone’ is that it is set at a point in time. It does not easily allow for changed circumstances for a particular pitch at rent review or lease renewal.
Nor does it flex to accommodate other cost pressures that affect occupiers. The shift to online retail has reduced sales from bricks and mortar shops. This trend has been exacerbated by more margin-eroding headwinds, including rising minimum wages, apprenticeship levies and the post-EU referendum decline in sterling, which sent stock prices higher. The old rent model is now too inflexible and out of date for most locations.
In the UK turnover rents have found favour in certain formats, such as outlet centres, but there has been resistance to more widespread adoption. Overall, landlords have been reluctant to commit to this type of leases, given the increased business and commercial risk associated with the terms. Moreover, turnover-based leases demand more hands-on asset management on the part of landlords to maximise footfall and ‘turnover’ and, therefore, rent.
Regardless of landlords’ historic reluctance, tying rent to a tenant’s trading performance has the advantage of better aligning the interests of landlord and tenant to mutual benefit. For example, while the landlord receives a lower rent in a downturn they share in an ‘equity-style’ upside in the good times. Equally, such an approach should help tenants to navigate the ups and downs of market cycles, hopefully reducing the risk of tenant failure, and the consequential impact on landlords of having to pay business rates on empty properties, reduced visitor appeal and increased irrecoverable costs.
As turnover lease models develop, landlords are likely to be more interested in the tenant’s performance at the premises. Landlords might insist on the inclusion of specific tenant covenants to increase their control over the tenant’s operations and improve visibility on performance, such as demanding timely data flows from which to calculate rent balances. This increase in transparency would also provide landlords with more ‘early warnings’ of when a tenant is starting to struggle.
Landlords are also likely to require more transparent and negotiated trading forecasts, enabling the parties to predict trading more accurately and agree sustainable levels of turnover. The turnover model may well drive shorter leases and provide landlords with more opportunities to break leases where tenants are failing to deliver the required level of turnover. A consequence of this is that tenants may well find that they start to sign away the protections of security of tenure they have always enjoyed courtesy of the Landlord and Tenant Act 1954.