Has the COVID-19 pandemic saved the turnover rent lease?

Turnover rent leases have always been rare. In fact, so unusual are they that I’m confident I can recall pretty much every one that has crossed my desk in recent years.

What is a turnover rent lease?

If you have not encountered the term, a turnover rent lease is one where although there is a baseline rent, the rent is otherwise calculated by reference to the turnover generated by the tenant’s business. Terms can vary considerably, but the following are typical models:

• The principal rent is based upon a percentage (usually 75 or 80 percent) of the open market rent, plus a fixed percentage of the tenant’s turnover to the extent it exceeds the principal rent.
• The rent is based solely on the tenant’s turnover, but with the tenant guaranteeing a minimum amount of turnover. If this model is used, there is usually also a maximum turnover, above which the landlord will receive no benefit.
• The rent is based on the tenant’s turnover, the tenant paying an agreed base rent with annual uplifts of the base rent payable. The uplifts will be based upon any increase in turnover for the previous accounting period.

Of course, whatever the model, the key for the parties is to balance the baseline rent against the correct proportion of turnover rent.

Unproven businesses

While turnover rent leases are occasionally encountered in the leisure and hospitality industries, most often they appear in retail where the tenant’s business is unproven; either a new business venture or an established business which is expanding into a new location or larger premises. From the tenant’s point of view, it means that they benefit from a lower fixed cost base as they work to establish themselves. The landlord takes a gamble, but stands to benefit if and when the business becomes successful.

The online threat to retail

In recent years, online shopping has proved the greatest threat to traditional retail. Even for products where consumers perceive a need to see, touch and ask questions before they commit to buying – books and electrical items are classic examples – many simply treat shops as test and advice showrooms, before ultimately purchasing online. This has had a significant impact on turnover for many retailers, making turnover rent leases ever more unattractive for landlords.

COVID-19

And then came lockdown, the single biggest calamity ever faced by traditional footfall businesses in the UK. Not only has the pandemic affected short to medium term cashflow, it has also brought the long-term viability of the traditional high street into doubt. “Non-essential retail” is again open for business, but social distancing measures and low public confidence continue to keep customer numbers significantly reduced.

Even where they remain profitable, retailers faced with the distinct possibility of ever tighter margins will look for greater flexibility from landlords, who are themselves aware that finding a new tenant may not be easy. Even if a potential new tenant can be found, negotiations are likely to be tough. For this reason (I predict!) turnover rent leases will begin to see a resurgence.

Factors to consider in negotiations

Landlords and tenants should be aware that turnover rent leases create a number of issues atypical of standard leasehold negotiations. These include:

Defining turnover

Defining turnover is usually the hardest part of the negotiation. In the past, this would simply have amounted to the total physical sales taken through the tills on the premises. Nowadays, landlords will seek to include within the lease as wide a definition of turnover as possible, to include, in particular, online sales and click-and-collect orders placed remotely but collected in store. Tenants on the other hand will be keen to exclude anything without a sufficient nexus to the shop, as well as problematic items such as staff discounts and gift vouchers.

Confidentiality

The nature of a turnover rent lease may require a wide range of sensitive financial information to be made available to the landlord in support of the tenant’s turnover certificate. The tenant will therefore be keen to incorporate a confidentiality provision to ensure this information is not shared more widely. If the lease is registrable at the Land Registry, both the landlord and the tenant will want to ensure that information such as base rent, thresholds and percentages are redacted. To achieve this, there should be provision to allow the landlord to provide the tenant with an Exempt Information Document (EID) lease for the purpose of registration.

“Keep open” provisions

These require tenants to keep the premises open for trade between certain hours, thereby continuing to generate turnover and protecting the landlord’s income stream. While there are usually exceptions to this obligation, for example where damage to the premises makes opening impossible, the COVID-19 lockdown serves as a warning to tenants to ensure that exceptions include force majeure events and, specifically, epidemics and pandemics.

Deemed turnover provisions

If the tenant breaches the keep open provisions, the landlord will want to be able protect their income by assuming a deemed turnover based on past trading.

Alienation

What happens in the event of an assignment or sub-letting? To avoid problems, turnover rent leases may be for shorter terms and prohibit alienation or, alternatively, the payment provisions may be stated as being personal to the named tenant. If the latter, it is important for the landlord to ensure that on assignment or sub-letting, the full open market rent is payable.