2020: the return of turnover rents? Lessons from CVAs in the retail and casual dining sector

For many years an institutional rack rent lease has been recognisable by:

• five yearly rent review cycles on an upwards only basis;
  
  
• a term of at least ten years, often with a break at year 5 to coincide with the first rent review; and
  
  
• a fixed passing rent with an initial rent free or other incentives, and a further rent free if the tenant does not exercise its break.

Landlords and their lenders have become accustomed to this structure. It facilitates a strong headline rent for valuation purposes, provides for a certain return and protects the landlord from changing market forces affecting the tenant's business. 

However, rent frees and start-of-term incentives can hide the true cost of the lease over time. Leases signed in more favourable economic times with upwards only rent reviews have largely been blamed for the burden that rents can represent to tenants in tougher economic conditions. Although there have been other significant factors affecting the sector in the last few years (high business rates, new online disrupters and increased supply chain and employment costs to name a few), the fixed nature of rental payments leaves tenants with little room to manoeuvre to adapt to changing market pressures, even when central balance sheet costs are aggressively reduced.

Predating the COVID-19 crisis, there were murmurings of a return to turnover rents, but the case has been put forward by tenants more strongly in the last few months. Turnover rents can provide a rental structure:

• reflective of the success of the underlying business;
  
  
• that allows both the landlord and the tenant to share in the upside, but which provides downside protection for the tenant's business;
  
  
• that eases the cashflow burden of rent; and
  
  
• which provides a rental figure appropriate to the asset and the business at any given time.

Aside from the COVID-19 crisis, landlords have long understood that to invest in a property is to invest in a sector. Asset management that understands the business of the underlying tenant is a proven method of generating better returns. Landlords are not afraid to make capital investment into property to achieve this. However, proposed changes to rental structures are harder for landlords to accept.  Whilst the COVID-19 crisis has led the way for conversations around additional rent frees and rent deferments, landlords are still wary of a move away from the traditional towards the turnover rent.

Clearly the conversation cannot be about protecting tenants alone. Landlords (and their lenders) will identify certainty as a key factor in the success of their investments. Turnover rents are by their nature uncertain, but they can be drafted to contain safeguards for landlords such as:

• a mutual break right so that landlords can exit the lease if the rents are too low and they can replace the current tenant with a better-performing one;
  
  
• minimum guaranteed rental amounts (base rents) that are reviewed over time in line with the market or a recognised index such as the RPI. Traditionally this base rent represented around 80% of the open market rent;
  
  
• a "look back" period in which a balancing rent is due if turnover rent paid through that period hasn't reached a certain level;
  
  
• a prohibition on assignment or alienation, with an offer-back clause or break right for use if the tenant wanted to exit, or else provisions whereby the rents switch to "open market" after an assignment;
  
  
• "keep open" requirements and performance criteria; and
  
  
• specified fixed rents on any days in which the property is not open to trade and should have been.

Undoubtedly, turnover rents require a degree of collaboration between the landlord and tenant. They also require a willingness on the tenant's side to share more financial and trading information than they have traditionally done and can involve a certain amount of administrative effort in compiling and presenting trade figures regularly.  The treatment of online sales and deliveries need to be carefully considered, although the historic difficulties around properly attributing these sales to the turnover of a given site have largely been addressed through modern technology and accounting practices.

It is unlikely that landlords can offer the traditional start-of-term incentives as well as a turnover rent structure. For many tenants, a rental structure that enables them to operate while "bedding in" the store is equally desirable.  Over the course of the term, many tenants are happy to accept paying a higher rent overall when trading is good, in return for the downside protection. Moving away from headline rents and looking at overall return, in the way that other investments are reviewed, would be a fundamental change in valuing property but not necessarily for the worse (with the right protections).

With the latest wave of administrations and restructuring proposals since the March 2020 quarter, the sector is set to suffer a harder awakening in the lifting of lockdown than it experienced in lockdown itself.  The timing has never been more pressing to consider alternative ways to structure rent.  All parties are incentivised to challenge conventional views of lease rental payments.  This does not mean forgetting each other's redlines. Asset performance will surely be at its best where landlord and tenant interests are truly aligned. A rental structure properly assessed against performance, underwritten by performance criteria, and with a guaranteed minimum return could be a logical and equitable way to navigate the difficulties facing the sector in the immediate future, but also for the longer term.