The UK retail market has faced a challenging period in recent years.
It has had to deal with challenges from a number of factors, including Brexit, the Covid-19 pandemic, the cost of living crisis, increasing business rates and greater energy costs.
Landlords are engaging with tenants to consider more commercial alternatives in respect of commercial property.
Flexibility regarding alienation, use and term length is important. However, as rent is usually the tenant’s largest outgoing, there is a question of whether there should be flexibility regarding rent.
One way of obtaining flexibility is to have a turnover rent.
Our expert retail lawyers explore how turnover rent is reshaping commercial leasing in response to economic pressures and evolving tenant needs.
What is a turnover rent?
There are two forms of turnover rent leases:
- Turnover top-up lease, where the tenant pays a minimum base rate plus turnover rent.
- Pure turnover lease, where the whole rent is calculated as a percentage of the tenant’s annual turnover.
The traditional turnover-based leases have provided for the tenant to pay a base rent plus a top-up element calculated upon turnover.
However, the growth of shorter, more flexible leases has seen an increasing use of pure turnover lease arrangements, i.e., where there is no base rent.
For the tenant, this provides flexibility, whereas landlords may regard the risk as acceptable for short, low-value lettings, where the tenant’s business model is simple.
Where a turnover rent is being negotiated, the landlord may also seek to limit the risk by incorporating flexible landlord breaks so that the arrangement can be terminated if it is not working out.
How do you calculate the turnover rent?
There are a number of factors which affect the level at which the base rent and turnover percentage are fixed. There are three main methods for calculating the turnover rent.
These are as follows:
- Straight turnover rent - which is the simple method. It is a matter of applying the agreed percentage to the gross turnover.
- Modified turnover rent - using this method, the percentage is applied to the amount by which the gross turnover exceeds an agreed threshold, often the base rent.
- Threshold turnover rent - under the threshold method, the turnover element of the rent is the amount in which the agreed percentage of the gross turnover exceeds the base rent.
The landlord’s intention is that the rent figure should be at least the open market rental value. As you can see from the examples above, the calculation alters the rent.
What should be included in the turnover calculation?
Those in the retail industry may generate turnover in an increasing number of ways, for example:
- Traditional at-till purchases.
- ‘Click and collect’ where customers purchase online but the goods are collected in-store.
- Customers may purchase gift vouchers online or in a store and then use those vouchers at a different store.
The underlying principle is that the calculation of turnover should reflect sales from the premises and be properly attributable to the premises, but this can pose problems.
For example, some tenants operate regional stores, which serve as cost and profit centres for a number of local stores.
Depending on a tenant’s arrangement, there may be resistance to applying this principle in the broadest sense.
What is excluded from the turnover calculation?
The idea is that it is a turnover rent, not a profits rent. Therefore, most costs are not deductible.
The following are usual deductions:
- VAT
- Amounts reasonably and properly allowed to customers on trade-ins.
- Amounts of any cash refunds or credits given on return of goods or services, so long as it does not exceed the sale price and so long as the sale was previously included in the turnover figure.
- Allowances made for defective or unsatisfactory goods, so long as it does not exceed the sale price, and so long as the sale was previously included in the turnover figure.
What are the pros and cons of having a turnover rent?
The traditional model of a rack rent lease is well-established and familiar.
A rate is negotiated, usually on an annual basis, and is paid in equal quarterly instalments in advance. If the lease is of a sufficient length, rent review provisions allow for a reassessment of the rent at regular intervals, by reference to the then open market rent.
Usually, the review process will be on the basis that the rent can only go up, never down. Other than that, the rent as negotiated does not change.
Regardless of whether the tenant is trading profitably, and regardless of what use the tenant actually makes of the property, the rent is a known figure.
That model has the merit of predictability and allows the landlord to make a straightforward calculation of the return on investment, but it is inflexible.
Flexibility means having a fluctuating level of rent, and the mechanism for achieving that which has found some market acceptance is for the amount of rent to be calculated in part by reference to the turnover which the tenant achieves from the premises.
The pros and cons for the landlord and tenant may vary. The attractions from the tenant’s side are not hard to see: in poor trading periods, there is a degree of downward adjustment of property costs to insulate the tenant from the impact.
Moreover, the landlord is incentivised to promote the property and keep it well-managed, well-maintained and fully let, with a view to maximising its rental income. That is always true, but the relationship is more direct, where rents are payable on a turnover basis.
The attraction to the landlord is less obvious since the arrangement involves assuming a part of the tenant’s risk, but there is also the potential to participate in profits and achieve a better rental income than would otherwise be the case.
More importantly, by offering the tenant something of a helping hand in difficult circumstances, a turnover rent promotes the sustainability of the tenant’s business and so reduces the risk of tenant insolvency and rental voids.
Given the significance of void property costs now, this is an increasingly important consideration for landlords.
Landlords may try to build in terms to protect their position, such as:
- A landlord’s break option.
- A ‘success payment’ for the landlord, if turnover exceeds a specified threshold (in the form of a one-off payment or an uplift in the rent); or
- A ‘look back’ period is when a balancing rent is due if the turnover-based element of rent has failed to reach certain levels.
Complexity
The idea of turnover rent is a simple one, but providing the details of it in lease drafting in a way that is fair to either party requires careful thought and negotiation.
The draft has to take into account a variety of practical implications of the shift away from a fixed rent, as well as anticipate changes in trading circumstances.
Operators in the retail sector continue to demonstrate ingenuity in devising new methods of generating custom: shops may enter into home delivery arrangements with operators, which can also create challenges in assessing rent on a store’s turnover and how to capture it as part of the turnover calculation.
Contact Our Retail Team
If you’re a landlord or tenant considering a turnover rent arrangement, our experienced retail lawyers can guide you through the legal and commercial implications.
01619414000
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Jennifer Hartley
Senior Associate
Jennifer qualified as a solicitor in January 2020 after completing her training with a specialist real estate firm. She joined Myerson upon qualification and has since become an integral part of the Property Litigation team, applying her expertise to a diverse range of contentious property matters.
Her practice covers a broad spectrum of issues, including TOLATA claims, residential and commercial landlord and tenant disputes, lease renewals, forfeiture, and advising on the right of first refusal. She also regularly advises on lease extensions and enfranchisement matters, guiding individuals and property owners through often complex statutory processes.
About Jennifer Hartley