Turnover rents are nothing new but, as we all know, this strange year has put immense pressure on both landlords and occupiers and the pandemic has upturned much of what parties have long taken for granted.
The market has been steadily moving in favour of turnover leases over the last few years – not least because the growth of online retailing and other delivery services have chipped away at the revenues of bricks and mortar tenants.
Turnover rents have advantages and disadvantages for both parties and can be complex both to negotiate and to document. It’s therefore important to consider some key points so that landlords and tenants can come out of this crisis with their long-term economic interests aligned.
1. How much?
This is, unsurprisingly, the first big question and can be dealt with in a variety of different ways.
Should there be a base rent or turnover only? Should there be a cap on a maximum rent that can be paid? At what threshold does turnover kick in and at what percentage?
One of the key advantages of a turnover rent is that it can enable a landlord to take a smaller slice of the rent during times of hardship and a larger slice during times of success. A tiered approach could work well here so that the first ‘slice’ is a lower turnover percentage that ramps up as turnover increases – or perhaps including a one-off success fee in the event of a certain target being reached.
2. What’s included?
There are certain established norms and fairly well-settled definitions of “gross turnover” so that income from all premises-related activities is captured. However, as the nature of retail and restaurant trade changes, departures from this are becoming increasingly necessary.
One of the big concerns for retail is “showrooming”, particularly in desirable locations such as Soho or Mayfair – the added brand value can be huge but it’s tricky to establish how much of a tenant’s revenue is attributable to a particular physical store. For restaurants and bars, whilst this is less of a concern, the increase in at-home delivery services or associated online retail may also need to be captured.
Some industries are more vulnerable to this than others and, for this reason, it’s important for a landlord to understand how the tenant will use the property and ensure this is sensibly controlled. This enables the landlord to properly decide how to structure the mix of base and turnover rent so as to minimise potential income risk.
Although relatively rare, it’s worth considering whether a landlord could negotiate a share of online revenue perhaps limited to that which is generated within a certain distance of the premises. The feasibility of this will depend on the nature and location of the store but landlords may argue that this is a fair trade-off for a reduced fixed rent.
There are other considerations, particularly relating to online sales. For example, whether to include purchases where there is an element of store interaction (such as click and collect or an order being placed via an instore terminal or ordering service). Similarly, is it fair that online returns are deducted from in-store turnover particularly taking into account any retailers returns policy that may encourage in-store returns at a lower cost to the consumer?
Caution should be exercised when allowing specific carve-outs from the definition of turnover. Any exceptions open up the possibility of sales manipulation so as to minimise turnover.
3. Certainty of income
A key landlord concern when considering turnover leases has always been certainty of income – particularly from a valuation perspective and when it comes to dealing with any lenders. This is one of the drivers as to whether or not a base rent is included. Another option is to include a landlord break right so that, after an initial settling in period, if the turnover rent falls below a certain level, the lease can be terminated. If this is a consideration, the lease should be excluded from the security of tenure provisions of the Landlord and Tenant Act 1954.
4. Alienation
Alienation is notoriously tricky for turnover leases. It’s not uncommon to see underletting and assignment entirely prohibited or, if allowed, additional provisions put in place which typically include one or more of the following:
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switching to an open market rent on assignment (with care being taken over the timing of any calculation to avoid delays or a situation where an assignee takes over a lease with an uncertain rent);
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a right of pre-emption – but any security of tenure should be considered and a tenant may want to exclude a potential disposal as part of a business sale;
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switching to open market rent for a period after assignment followed by the calculation of a new turnover rent based on the new tenant’s margins and turnover levels; and/or
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ensuring that any company (including any group company sharing occupation) contributes to the turnover generated (whilst avoiding double counting).
Consideration should also be given to rent review implications and, where relevant, such restrictions should be disregarded.
Finally, if a landlord wishes to claim rent arrears from a previous tenant then they should always consider the former tenant’s statutory right to a new overriding lease on the same terms as the current lease (including the turnover percentage). This may affect the landlord’s decision as to which former tenant to demand arrears from given turnover percentages are generally quite personal to an entity.
5. Keep open
Where the turnover rent is generated from a store, the ‘keep open’ covenant is more important than ever and any documentation should cater for what happens to the rent in the event of an unauthorised closure.
There are broadly two approaches to this:
Each approach has different merits. The “gross up” approach is simple, and works well where there is no base rent, but care should be taken if a continued pattern of closures impacts on trade on the open days.
Similarly, applying a specific rent for non-trading days can work well but care must be taken to ensure that the liquidated damages sum is a genuine pre-estimate of loss (so as not to be void as a penalty clause). A typical approach is to say the amount is a multiple of the base rent. For example: where the base is 80% of open market rent, the ‘closed rent’ is 1.25% of the base rent ensuring the landlord then receives full open market rent. This is clearly more complex where rent is turnover only.
6. Enforced closure
Sticking with the keep open theme, it’s common to specify scenarios where closure is permitted and doesn’t trigger the rental provisions outlined above. These will typically include physical damage, limited periods for assignments and tenant works, or legal restrictions.
There is an understandable trend from tenants to ensure that pandemic-related closures are on the ‘permitted’ list. Consideration should be given to the extent to which this is allowed. Should it just be for government enforced closure? Should it apply for COVID-19 closures only or other pandemics/scenarios and to what extent should there be any maximum period?
7. Confidentiality
For any turnover lease to operate effectively, a significant amount of collaboration between landlord and tenant is required.
In particular, occupiers need to share considerably more financial and trading information than they have done traditionally and, in doing so, overcome a historic distrust of this information being in broad circulation.
The key to keeping everyone happy is to ensure that such data is used only for its proper intended purpose with clear obligations on a landlord not to share that information more widely save where may be reasonably necessary – for example with lenders or advisers.
From a landlord’s perspective, turnover terms offered to one tenant may not be suitable for another and so those leases may include provisions that the landlord may not want the wider market being aware of. In such cases, where a lease is registrable at the Land Registry, it’s important to ensure that the lease includes a mechanism for redacting confidential provisions upon registration.
8. Payment mechanics
Typically, turnover payments operate in a similar way to service charge – the tenant pays an on-account turnover rent estimate with an annual reconciliation against actual turnover following the provision of a certificate.
It’s worth considering how often information should be provided, who is able to certify its accuracy and, from a tenant’s perspective ensuring that lump sum payments are avoided so that there isn’t a risk of a single large capital outlay either as a result of reconciliation or busy periods such as Christmas.
For administrative ease, parties may want to consider tying the annual turnover reconciliation date with a financial year end so that certificates of turnover can be more easily produced.
9. Tax
From a tenant’s perspective, stamp duty land tax (SDLT) in respect of the grant of the lease is more complex for turnover leases.
At the time the lease is granted, the tenant will be required to make a reasonable estimate of the turnover rent it anticipates will be payable for each of the first five years of the term and pay SDLT on that basis. At the end of the fifth year (or, if earlier, when the lease ends), the tenant will then have to recalculate its SDLT liability based on the known rents, and submit a return and pay any additional tax due (or reclaim overpaid tax) as necessary. Potentially, if at that point some of the turnover figures for the first five years still remain uncertain, a further return may have to be submitted once the figures have been finalised. In short, the compliance burden can be significant.
It’s also important to remember this upon any assignment as the incoming tenant should ensure that they have access to any historic information which may be needed as part of their tax calculations.
10. Administrative costs
The increased reporting, reviewing and collaboration will place, not only an administrative burden on both parties, but also lead to increased costs. Parties should consider who should bear the brunt of this and the extent to which this can be covered through the service charge for the landlord.
Careful consideration needed
As occupiers rise to the challenge of reduced footfall and an increase in working from home, the market for more ‘away from store’ services and goods is likely to continue long after COVID is a distant memory. The result of this is that turnover rent looks increasingly set to become a staple part of the lease landscape and careful consideration needs to be given to the key terms to ensure a successful and happy relationship between landlords and tenants.
An earlier version of this article appeared in Estates Gazette.
Authored by Olivia Vice
