Are Turnover Rents a Good Option for Commercial Buildings?
Turnover-based rents have been prevalent in the retail and restaurant sector for many years. However, there is increasing interest in the concept, in large part driven by the impact of the COVID-19 pandemic, which has left many businesses struggling to meet their fixed rent payments when their turnover has been significantly lower than normal.
Due to the current economic climate and new-found need for flexibility, many landlords and investors are likely to be looking at the idea of turnover rents for the first time, especially where tenants may be requesting this option.
Knowing whether it is a good idea to grant a turnover rent lease on any type of commercial property will depend on the circumstances. A good starting point is to gain a better understanding of exactly what they are, how they work and the key issues landlords and investors need to consider.
What are turnover rents?
In its most basic form, turnover rent means that a commercial tenant pays a percentage of their turnover to their landlord, rather than a fixed monthly rent. This can be their annual turnover, based on the previous period, or their turnover for any agreed period.
Variations on the concept include margin-based rents, where the rent is calculated based on the business’s profits, rather than turnover, as well as hybrid models, where some part of the rent is fixed and this is topped up with a percentage of the business’s turnover or profits.
How do turnover rents work?
The principle behind turnover rents is that they keep tenants’ rents in line with how well their business is doing. If the business’s turnover increases, they pay more rent but if turnover falls, they pay less.
Turnover rents are usually calculated on a percentage of a business’s turnover. While turnover rents have traditionally been calculated on the previous year’s turnover, given the current economic uncertainty facing many businesses, quarterly or even monthly turnover-based rent may be a more attractive option.
Looking at turnover across a shorter period may potentially be a better option for landlords at the moment as, with the economy beginning to recover from the worst of the pandemic’s impact, it is likely turnovers for many businesses will increase significantly compared to the previous year.
There will usually be a set minimum rent to be paid regardless of turnover. Tenants may also seek to negotiate a ceiling to the rent, setting a maximum that will be paid whatever their turnover is.
Where are turnover rents normally used?
Turnover rents are well established in the retail and restaurant sectors because these sectors generate profit from tangible goods that traditionally go through a till, meaning they can be accounted for relatively easily. However, internet sales, click and collect services and gift voucher schemes add a layer of complication.
Turnover rents can also be particularly attractive to tenants in these sectors as there is a lot of seasonality in trade and also in sectors where starting a new business may be considered particularly risky. Retail and hospitality are prime examples of these and a turnover based rent model can make such premises much more attractive to potential tenants.
What do landlords and investors need to consider before granting turnover rent leases?
For commercial landlords, rents based on turnover can be advantageous for a number of reasons. Rental income increases when a tenant’s business is doing well. In the opposite scenario, landlords will receive less rental income but the flexibility may mean tenants are willing to stay and landlords are less likely to have empty premises. Flexibility may also be attractive to potential new tenants.
However, landlords will need to consider the risk that they may receive a lower rent if the tenant is not performing. They will also need to consider the requirements of any lenders, who may need additional security in the form of guarantees and rent deposits, as well as possibly requiring provision for windfall rents to be applied directly to the loan.
Turnover lease provisions are complex and to mitigate risk landlords should consider:
How the turnover rent is calculated – The definition of turnover is critical and it must reflect the tenant’s full income stream e.g. online orders, click and collect services, gift vouchers and discounts offered via loyalty schemes. This can prove more difficult if the tenant provides services rather than selling tangible products (e.g. offices and warehouse premises) or operates from multiple locations. How is turnover defined if a service is offered and can be established which location the profit was generated from?
Reconciliations – These will be needed to balance up turnover rent payments. Mechanisms for these and any balancing payments must be included in the lease.
Ensuring tenants are incentivised to maximise turnover – E.g. through the use of ‘keep open’ covenants, requiring the tenant to actively trade for the duration of the lease and by including mechanisms in the lease to enable the landlord to recover rent if the tenant fails to open for trade.
Prohibiting or additional restrictions on assignment – As an incoming assignee’s business will have a different predicted turnover, this could negatively impact the amount of rent the landlord receives under a turnover rent model. Landlords can protect themselves by, on assignment, having the ability to convert the lease to a rack rent lease, vary the turnover percentage, including a right of pre-emption (under which the tenant has to offer a surrender before making an assignment) or suspend the turnover rent temporarily until a new turnover percentage is agreed.
Ensuring access to confidential accounting information – Landlords will need access to the tenant’s accounts so they can be confident that the turnover figure the rent is based on is accurate.
Longmores’ view on turnover rents for non-retail commercial buildings
Turnover rent lends itself well to premises where the tenant generates an identifiable turnover from the property. Although this has traditionally been reserved for the retail sector, it may be well suited to the serviced office sector, where desk licences create a turnover that can be easily identified.
If a landlord is considering a turnover rent lease in a sector where they are uncommon, we would also advise landlords to seek valuation advice from a surveyor. Will the turnover rent impact the asset value and are comparables available? If the landlord is the trailblazer, it may be difficult to find comparables available. We will be watching the market with interest.
Speak to our Commercial Property team for expert advice on turnover rents
To discuss turnover rents or any other commercial property matter with our highly experienced Commercial Property team, please get in touch.