Turnover rents have been adopted by retail landlords as part of the solution to protect beleaguered retailers and leisure occupiers as they grapple with twin headwinds from the pandemic-induced recession and broader market forces driving structural change.
Retailers’ ability to pay rent – and remain solvent – during this protracted economic slowdown has strained an already tense relationship between landlords and retailers, evident in the sector’s low rental collection rates. According to data by Remit Consulting, just 50.5% of retailers’ quarterly rent due in June was collected 35 days after rent day. Among leisure SMEs, it was even worse: only 41.3%. Analysis by Remit Consulting suggests the ongoing moratorium on tenant eviction for non-payment of rents has established a divide between those trying to pay what they owe and those merely choosing not to. This lack of alignment in economic interests and collaborative behaviour is emblematic of the deep-rooted problems which have been rising for decades. It is leading to a growing number of landlords, including Hammerson and Legal & General, switching to turnover-based rents as part of a broader reset of the traditional landlord-tenant relationship in the retail and leisure SME sector. In this article, we will take a closer look at landlords and SMEs’ perspectives on turnover-based leases and what broader adoption might mean for the market.
The landlords’ perspective
Understandably, this leasing evolution begins with large institutional retail and leisure landlords. Institutional landlords have greater access to large pools of inexpensive debt facilities, from revolving credit facilities to corporate bonds, private placements and CMBS. With greater access to debt liquidity, major landlords have a more substantial negotiating hand than their smaller landlord peers and can offer struggling retail and leisure SMEs new flexible leases. In exchange, landlords will typically ask for some concessions, such as the removal of lease breaks, lease extensions, reduced incentives or commitments for additional space. In this way landlords can offset the twin downside risks from a turnover rent model: the threat of tenancy insolvency and asset value erosion. Turnover rents effectively operate as a sharing of occupiers’ risks and rewards. Collaborative sharing of risk and reward between landlord and corporate tenant can strengthen asset performance through partnership and increased involvement by landlords to support tenants’ revenues. This model helps struggling occupiers in the short term, realigns long-term economic interests and renews collaboration – all in return for sharing the upside when the good times return.
Indeed, the timing of the transition to risk and reward sharing leases favours landlords. Agreements reached in the middle of a recession ensure landlords share in retailers’ pain in reduced rents ‘today’ and lock in future value and the potential for super-profits ‘tomorrow’ if the economy rebounds sharply. There could also be an early mover advantage for retail landlords in helping to retain existing tenants while even increasing market share from retail and leisure corporates who are unwilling to sign new traditional ERV-based long-term leases, in favour of flexible alternatives.
But risk-sharing turnover leases are not the only solution. Indeed, many smaller landlords may be unable or unwilling to move entirely from ERV-based leasing to turnover leases, given the valuation and loan covenant implications discussed in our previous article. For smaller landlords, the solution may lie in other initiatives, such as a move to monthly ERV-based rents, rent deferrals, and partial settlement of outstanding rents in exchange for the kinds of tenant concessions already outlined. Smaller landlords may need to take a step back and understand what these shifts might mean for their business model. Likewise, lenders may need to think ahead for what might be asked of them by their borrowers in support of their occupiers.
Retail and leisure SMEs’ perspective
For retailers and leisure SMEs, this shift in the leasing model is unlikely to come without concessions. The question then becomes what kinds of concessions are SMEs prepared to accept? And how much turnover reward – or rental top-up based on store performance including omnichannel metrics – should retail and leisure SMEs be prepared to cede to landlords in return for lower rents today? There is no one-size-fits-all answer to these questions, it will be a function of, among other things, the SME’s corporate culture, existing shareholder structure, its balance sheet, supply chain, and revenue outlook. Indeed, many SME’s landlords will not offer these leases, which invites a new strand of negotiation as to the viability of exercising a break clause in favour of a corporate move, if considered to be long-term advantageous. Knowing these broader market trends can strengthen an SME’s negotiating hand with their landlords. It is one of the tools in their toolkit to manage the ongoing liquidity problems faced by SMEs in this period.
Tenants, landlords and lenders are intertwined in a value chain and will best navigate these economic challenges through an equitable balance of aligned interests. If you are a retail or leisure business, a commercial property landlord or lender, and wish to discuss how these issues affect your business model, please do get in touch with us and we will see how we can help.
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.