Major retail and leisure landlords are embracing turnover-based leases for tenants in a tacit acknowledgement that the UK’s leasing framework is not fit for purpose. Both Hammerson and Legal & General (LGIM Real Assets) have signalled their intention to pivot to a Continental European leasing model, characterised by increased occupier flexibility, rebased rents at lower levels and indexation replacing the existing rent-review system. Hammerson’s CEO David Atkins said: “The UK’s historic leasing model has served its time. It is outdated, inflexible and needs to change.”
LGIM Real Assets has developed a flexible partnerships model composed of four tiers to suit businesses from start-ups to superstores, recognising that the sweeping changes that have blazed through the retail sector in recent years are the result of well-established market – and cultural – forces. In recent years, the commercial landlord-tenant relationship has tilted and edged further towards zero-sum posturing, as both counterparties have grappled with the effects of technology-driven consumer behaviour changes on their underlying business models. This trend has been most acute in the retail and leisure sectors.
Covid-19 has exacerbated pre-existing rising tensions. The liquidity crisis affecting retailers and leisure SMEs hastened the demise of Intu, one of the UK’s largest (and most highly leveraged) retail landlords, which collapsed into administration in late June. While Intu’s problems entirely pre-dated the arrival of 2020, shockwaves reverberated throughout the UK, European and US retail sectors. Intu’s collapse was certainly an antecedent for the recent move of Hammerson and LGIM Real Assets towards the long-awaited restructuring of the leasing model for retail and leisure SMEs. On one level of analysis, Covid-19 was not necessary to expose the broken UK leasing model – it was already evident. The existing model is based on the Landlord and Tenant Act 1954 – which is underpinned by historical market evidence to determine a valuation based on estimated rental value (ERV). This incentivises short-termism (i.e. chasing highest rent payers) over long-term value creation (i.e. balancing retail and leisure assets’ vibrancy and brand mix to create long-term value). The current model has driven a wedge between landlords and retailers at a time when survival requires cooperation. With the problems in the status quo lingering for years, why did it take until a global pandemic that upended global economies to address structural failings in the property leasing market?
One part of the answer is that retail landlords have needed the impetus of the current crisis – in which their published rental collection rates have become a bellwether for the sector’s solvency crisis – to persuade lenders to share the burden of this structural transition. ERV valuations are underpinned by rental yields which are linked to loan covenants; switching to values based on turnover rents – during a recession, reduced investor confidence, transactional and leasing activity, as well as financing liquidity – will reduce asset valuations. Lenders will caution that playing around with leases will lead to lower valuations, causing some borrowers to breach loan covenants or instead inject fresh equity to cure the breach and prevent loans falling into default. Scaled up, this could force a revisit of lenders’ retail exposure and may require loan provisions. In sum, it unravels a highly intertwined value chain wherein economic interests are deeply rooted in the status quo.
Landlords and lenders’ mutual interest in keeping this house of cards afloat has stymied the evolution in the leasing market. To do otherwise might appear like a voluntary erosion of equity value. However, certain concessions can soften the pain to retail landlords’ balance sheets. Moreover, retail landlords are now accepting the writing is already on the wall, and Covid-19 was the accelerant of an inevitable change, allowing landlords to persuade lenders to shift the leasing model.
Indeed, it is not only Hammerson and LGIM Real Assets embracing this leasing shift – to a lesser extent, Capital & Counties, Shaftesbury and British Land have all indicated the partial, and in some cases, short-term, switch to turnover rents. For retail and leisure occupiers the momentum looks to be building towards a more consensual landlord-tenant relationship, but new terms are unlikely to be offered without concessions. For landlords, the decision to provide turnover-linked rents is just one of several tools available with which to navigate the current pandemic-induced solvency crisis and broader sector headwinds. In the second part of this article, we will consider the motivations and perspectives of both stakeholders for this leasing shift and the broader market implications.
BTG Advisory have acted for a number of retailers, hospitality and leisure businesses and their landlords and lenders, both prior to and during the current Covid-19 crisis. Many of these involve high profile names; we pride ourselves in our discretion when undertaking such assignments.
If your company is facing related issues and you would like to discuss your options, please get in touch with us today and let us help guide your decision-making process and counterparty negotiations.