Game over for the turnover lease?

A recent report from the Centre for Retail Research has shown that the British do more of their shopping online than any other nation.

Although creating numerous opportunities for logistics firms and warehouse operators, it is undeniable that this trend has disrupted the traditional retail models on the high streets and in shopping centres. Can the turnover lease, in its current form, survive this market upheaval or will it also require a comprehensive makeover?

A turnover lease is one where all or a proportion of the rent is, not fixed, and is instead determined in accordance with the turnover generated by the tenant at the premises. It is a means for landlords and tenants to share some of the risk and reward of operating from the premises.

As such, turnover leases are particularly suitable for unproven retail operations, where there is a new entrant to a particular market, or where a new operator is being tried in an untested or a newly upgraded location.  The tenant benefits from lower fixed costs at a time when it is struggling to become established, and while the landlord may take a potential hit in terms of revenue, there is always the possibility of receiving a higher income if the tenant is particularly successful.  The key is to balance the fixed rent against the correct proportion of turnover rent.

However, the trend towards consumers treating shops as showrooms – allowing them to test and receive advice on products before purchasing the item online – undermines this balance of risk and reward as well as posing numerous problems for landlords letting retail premises on turnover leases.  The boom in online shopping has ruptured the traditional correlation of footfall with turnover, which has been so important to landlords running shopping centres.

Challenge of Online Shopping

The trend for “showrooming” has been held up as one of the main causes for the demise of UK high-street chains Jessops and Comet. The growth of showrooming, however, is not always detrimental to physical retailers, particularly where they have such a strong online presence that the consumer ultimately purchases items through their website.

A landlord, on the other hand, that might be expecting a significant income to be coming from a turnover rent will be more concerned if they are not entitled to any share in the online revenue stream. For the tenant, attributing the source of the sale can be a tricky exercise.  For a landlord, knowledge of the prospective tenant’s business and their proposed plans for the use of the retail unit are vital when negotiating both the terms of the turnover lease and the appropriate level of turnover rent.

It is quite clear that some retail industries, such as electronics and book stores, are more vulnerable to showrooming than others. If there is a high risk of showrooming, then it would be wise for a landlord to have a high proportion of fixed rent and a low proportion of turnover rent so as to minimise the income risk faced by the landlord.

Protections

Landlords can put in place certain measures to protect themselves from the risk of showrooming.  The turnover lease can require the tenant to account to the landlord for online sales that have an interaction with the physical retail store. For example, the landlord may wish to include click and collect services and customer orders through online in-store terminals in the definition of the tenant’s turnover at the premises.

A landlord might also be able to negotiate a share of revenue generated by online sales within a specified geographical radius of a retail premises, as has happened in Australia. Some retailers might see this as a fair trade-off for having a reduced fixed rent; others, however, might feel that the significant investment in their online presence means this is not something in which the landlord should share, especially if their online prices match their in-store price.

A landlord might consider making the turnover rent personal to the first tenant.  This would mean that the full open market rent would be written into the lease with the discounted and turnover rents contained in a personal side deed to apply only for so long as that tenant is trading from the premises.

Accordingly, an assignee or undertenant would not benefit from the same arrangements their business might not suit the landlord, especially if there were a high degree of showrooming.  The landlord could always negotiate a further personal turnover rent concession if it felt that this was warranted, however.

An additional protection a landlord should consider is making sure that promotional or marketing costs they incur, such as Christmas lighting or events in a shopping centre, are fully or partially recoverable through the service charge, because they may not benefit from the increased footfall at the retail unit or in the shopping centre that is linked to this expenditure. In the past, these incurred costs may have directly resulted in higher footfall and correspondingly higher turnover rent.

Finally, the landlord might want to consider a break option should the turnover rent fail to reach a certain threshold over an agreed period of time.  The tenant is usually given an initial period to bed in but after, say, the first year, if there are two consecutive years when the turnover rent is not what it was expected to be, the landlord might want to break. For this reason, turnover leases may not carry security of tenure.

Calculation and Collection

The lease should have clear and unambiguous provisions governing the recording of the turnover including a detailed definition of what turnover comprises. Invariably this will be the hardest part of the negotiation. This is where the detail of any online sales should be covered.

The tenant is usually required to provide turnover certificates as well as making all account records available to the landlord, which will usually also want to have a right to audit the tenant’s figures to make sure that the correct amount of turnover rent is being paid.

Some things never change

Despite the justifiable concerns about the erosion of the turnover lease’s, effectiveness due to the rise of online shopping, the fundamental advantages of this form of lease remain for both landlords and tenants. Turnover leases are a means for the landlord and tenant to share both the risk and reward of retail activities at the unit. In ideal circumstances, the landlord and tenant retain a mutual interest in the success of the tenant’s business and enterprise.

So, provided that the turnover provisions in the lease sufficiently protect this partnership and the landlord is active in its retail management, the turnover lease has a future on the high streets and in the shopping centres of Britain.

This article first appeared in the RICS Property Journal and a link to the Centre for Retail Research can be found here.