Is the retail sector about to turnover a new lease?

This week, it was reported that the Crown Estate has written to some of its tenants, offering them the option of paying a turnover rent.

In addition, a recent nationwide survey conducted by Savills into the impact of Covid-19 on the leisure and retail sector found that 82% of the retailers surveyed are considering a re-gear of their existing lease to include turnover rent provisions.

Both news stories suggest that we may be about to see an upsurge in re-gear negotiations, particularly amongst those tenants who signed up to new leases 12-24 months ago when the property market (and the world in general) looked very different.

What is a re-gear?

The term “re-gear” is used to describe the renegotiation of a lease during the current term. Often, these renegotiations take place in the run up to a key lease event (for example a rent review or a break clause), or when the landlord and tenant decide to negotiate a lease renewal in advance of the contractual expiry date.

In legal terms, a re-gear of an existing lease will either be documented in a deed of variation, or by a surrender of the existing lease and immediate re-grant of a new lease on the renegotiated terms.

The lease re-gear will require the co-operation and agreement of both landlord and tenant, and consequently must offer some benefit to both parties. The benefit will need to be significant enough to merit the time and expense of renegotiating the original deal and in the case of the tenant, the potential cost of re-registering the new lease and potentially incurring further SDLT if the re-gear takes place during the first five years of the original lease term.

What is a turnover rent, and is it a good option?

A turnover rent is based on the tenant’s turnover at the premises. Often, the rent will be expressed as a percentage of the turnover.

Turnover rents are quite common in the retail sector, airports and petrol stations, as they allow a degree of risk to be shared between the landlord and the tenant.

Where a turnover rent is negotiated, the landlord will often prefer the tenant to pay a basic rent in addition to the turnover rent to ensure they are not exposed to the risk of receiving little or no rent, if the tenant is making no income from the property.

As to whether turnover rent represents a good option, that will depend on several factors, including the respective bargaining strength of the parties and the drafting of the rental obligations.

If a landlord and tenant are considering a re-gear of a lease to incorporate turnover rent provisions, here are a few points to consider:

1. Personal Obligation: Most commercial leases allow the tenant a degree of flexibility and permit the tenant to assign (transfer) the lease or underlet to a third party subject to obtaining the landlord’s consent. The negotiation of a turnover rent is likely to be geared towards the current tenant and its business, and so the parties may need to give some thought to whether the rent obligations should change in the event of an assignment or underletting.
2. Calculating turnover: This may sound straightforward, but much will depend on the nature of the tenant’s business and whether they derive their income from a number of sources. For example, should online and internet sales be included as well as those made from the premises? And how should the turnover calculation deal with customer returns? All these issues (and more!) will need to be considered when negotiating a turnover rent.
3. Accounting records: A turnover rent obligation will place the tenant under an onerous burden to demonstrate its turnover to the landlord. This may require the tenant to prepare specific accounts for the landlord’s benefit, to itemise the tenant’s income based on the formula provided for in the lease. In addition, most turnover leases will oblige the tenant to make it’s records available for inspection by the landlord, for the purpose of verifying the turnover information provided. This may give rise to confidentiality concerns on the tenant’s part.
4. Enforced periods of closure: What happens if the tenant is unable to trade following property damage or (as we have seen recently) during a period of enforced lockdown? A turnover rent clause will need to specify what should happen in such an event. One option is for the parties to agree a formula for calculating a “substituted rent” that will apply during such periods of closure, and often this will be based on an average day’s turnover from a previous rental period.
5. Tenant behaviour: Many retail leases will include “keep open” covenants, to ensure the tenant is maximising its income. Such obligations will be particularly important where the lease contains turnover rent obligations. If a tenant fails to comply with a “keep open” covenant, a landlord would have the right to damages, but would not have the right to apply to court for an injunction to force the Tenant to stay open and trade. This issue arose in the 1997 case of Co-operative Insurance Society v Argyll Stores (Holdings) where the court decided that it would not be in the public interest to force someone to carry on a business at a loss if there was an alternative by which the injured party could be compensated (e.g. by paying damages).
6. Lack of control: Under a turnover rent clause, the rent obligations will be directly linked to the success (or failure) of the tenant’s business. This can be a difficult issue for landlord’s, who will have no direct control over the way the tenant chooses to run its business. In times past, landlord’s may have felt some comfort in agreeing turnover rent clauses with household names. This is unlikely to be the case now, with even the largest retailers facing store closures and staff redundancies. Any proposal to negotiate turnover rents will require a thorough consideration of the tenants financial standing and plans for the future.

In conclusion

The Government’s Code of Practice for commercial property relationships contains advice and guidance on how landlords and tenants should work together to “ensure the continuation of viable businesses”. However, the code also recognises that “Every landlord and tenant relationship is different, and we respect the rights of parties to settle on an arrangement that reflect this”.

Turnover rents will not suit everyone, and they can be complicated and time-consuming to negotiate as there are many factors to consider.

In the current climate, turnover rents are likely to be more attractive to tenants rather than landlord’s for obvious reasons. A tenant paying a rent linked to their income will have greater control over their overheads, while for landlords, the usual benefit of receiving an immediate uplift in rents during periods of increased trading are unlikely to be on offer for some time.

Consequently, a tenant seeking a more attractive turnover rent arrangement may find that they must give up something in return (e.g. a break option, an increase in term length, or some additional security) in order to persuade a reluctant landlord.

If you would like any advice about any of the issues raised in this article, please contact our Real Estate team.