With tenants, and therefore landlords, being hit hard financially by the unexpected impact of Coronavirus and no clear picture of how the situation will resolve itself, or even whether a similar event could occur in the future, turnover rent may be a way for these parties to share the impact moving forwards.
Why might you consider it?
Turnover rent, whilst not entirely uncommon previously, became a big topic in 2020 and could become much more common still as new leases are entered into and existing leases are renegotiated and renewed. Traditionally, the rental structure for commercial leases is that the tenant will pay a fixed annual rent. This rent is often subject to a periodic ‘market review’, although commonly the rent review is a one-way street: even in poor economic circumstances the rent will not drop, so many tenants are stuck with rents that can only go up.
For tenants that require a physical presence on the high street for their business model e.g. much retail, leisure & hospitality, turnover rents can help to mitigate the risks of fixed rents and ultimately lead to a fairer balance of risk sharing between landlord and tenant. It is true that in tougher times the landlord receives less rent, (assuming the tenant does not go completely bust), but in the good times it partakes in the upside of strong trading in a way that it otherwise would not under the traditional rent structure.
How does Turnover Rent work?
Turnover rent typically has two elements: a base rent and a turnover rent, although a pure turnover rent is possible. The base rent functions in the traditional rent sense and is a minimum sum which will be paid by the tenant to the landlord on a regular basis: monthly or quarterly. Base rents are often subject to periodic review, typically in line with a price index or by linking it to an agreed percentage of the full open market rental value of the property.
The turnover element is a top-up on the base rent and is linked to the financial performance of the tenant. An agreed percentage of the tenant’s turnover from their premises will be paid over to the landlord on a regular basis (often quarterly due to administrative demands). The percentage might feature an escalator increase as turnover thresholds are exceeded or might be a flat percentage. There may also be a capped sum which provides a maximum amount payable.
As with any commercial lease, the amount of base rent and percentage of turnover, (and its exact mechanism), are commercial terms to be agreed between the parties. Many factors will come into play, including the current state of the market, the value of the property and the relative bargaining power of the landlord and tenant.
Key Points to Think About
Turnover rent can be a little trickier to organise than traditional rent and to save time and fees some points need full consideration up front, before Heads of Terms hit the solicitor’s desk.
Capturing Turnover – This is perhaps the element of a turnover rent that requires most thought and negotiation. There needs to be a balance between what turnover is captured as rent, and what is actually affordable for a tenant, both in the current depressed economic climate, and following a move into what will hopefully be a period of recovery and renewal. There are, of course, various “standard” captures, such as traditional point-of-sale purchases reflecting sales from, and attributable to, the premises. However, trading practices are changing, even for bricks and mortar businesses. “Showrooming” means that retail stores find themselves increasingly treated as showrooms, facilitating online purchases, and landlords are looking for ways to capture the influence of stores on online sales when calculating turnover rents.
So, it is now relatively standard for in-store click-and-collect revenues to be included in turnover. But what about when online purchases are returned in-store, should these be netted off that store’s turnover? There is also a growing trend for purchases made via an app (i.e payment is made to the central business), but collected in store. For example, a subscription coffee service whereby customers can pay a monthly subscription for unlimited coffee and a QR code is scanned in-store on collection of their coffee. Does the notional cost of this coffee count towards store turnover?
Keep Open Obligations – Landlords will often require “keep open” obligations in relation to the premises to protect the turnover rent. These may take the form of minimum opening hours, or trading days per annum. These obligations can be difficult to enforce, but to provide some teeth to the provisions leases commonly include either a fixed penalty or an assumption that turnover is generated even when the premises are closed.
Alienation – It an be difficult to allow for underletting or assignment of a lease that has a turnover rent, and increasingly so the more the lease has been drafted for a specific industry or tenant. Therefore, some landlords prefer to include open market rent provisions in the main lease and house the turnover provisions in a side letter, which makes them personal to the original tenant. If the main lease is to contain the turnover rent provisions, it could make the lease less attractive to other parties and so it can be a good idea to include a landlord’s pre-emption right or a switch to open market rent on tenant disposal.
Stamp Duty Land Tax – For the tenant it is worth appreciating that SDLT liability is more complicated for turnover rents, when the exact level of the rent payable is not known at the outset of the term. Tenants will pay stamp duty on a reasonable estimate of the turnover rent and this needs to be assessed at the end of the first five years and, if necessary, further tax paid.
Administration & Information sharing – turnover arrangements undoubtedly impose a greater administrative burden on both parties in terms of record-keeping, and the supply, verification and processing of financial information. Precise and comprehensive lease drafting is required to ensure that issues are foreseen and resolved. Also some tenants may be wary of sharing the commercial trading data necessary to enable a turnover rent to work, in which case this type of lease won’t be for them, as transparency is key.
Alternatives to Turnover Rent
Of course, turnover rent is not the only rental alternative to a rack rent and changing market trends may drive greater innovation in rental structures. For example, all-inclusive rents, where the tenant pays a flat rate and the landlord bears the risk of fluctuations in the cost of insurance, services, rates and property maintenance, can be a good solution for shorter term lettings where landlords are eager to fill space and tenants want certainty of outgoings.
Some jurisdictions have also seen shopping mall operators adopting an opportunity-based rent, whereby the mall owner accepts responsibility for footfall to the premises, and the tenant pays rent based on such footfall. In such model, it is incumbent on the tenant to maximise its profit from that opportunity.
Other creative and flexible rental models may well be forthcoming in the near future as businesses reliant upon physical premises seek to re-build and capitalise on changing retail practices in 2021 and beyond.
For more information please contact Rebecca Cobbs.