We Can’t Stop The Rise In Turnover Leases
When New Look announced its intention to seek a CVA in October, central to proposals was a request to landlords to accept turnover leases at more than 400 outlets. This move, one CVA among many, represents a distinct turning point for retailers and landlords.
“The business model of paying a fixed rent isn’t sustainable when there is either no income or significantly reduced sales coming into the store,” DLA Piper partner Susan Samuel said. “This is what the global pandemic has laid bare. The retail, leisure and food and beverage sectors have been under huge strain in recent years, so already there is no long queue of tenants looking to take empty spaces, which could make a landlord liable for empty units and the associated costs.”
The question now is how landlords are going to cope with this new normal. If managed correctly, the DLA Piper team said that new relationships could emerge between tenants and landlords that improve the retail environment for everyone.
The New Lease
Turnover leases have always comprised a small section of retail and leisure leases. Previously, however, they have generally been combined with an element of a base rent; a traditional 10-year lease, say, with a five-year break clause. These leases were very much geared in the landlord’s favour, guaranteeing a rental payment even if a store was closed, for example.
The growth of online sales has been gradually disrupting this model, while raising questions about how to create a revenue-based lease in today’s retail environment.
“What is revenue?” Samuel asked. “How can online sales be captured where they are generated from a store? Some landlords and retailers are including sales from a postcode area to capture income derived from a store, while others are looking at charging on a footfall basis.”
The move to a revenue only lease involves a significant change in a landlord’s mindset, Samuel said. They need to move away from assessing a potential tenant’s covenant to assessing the actual business and whether it’s likely to hit revenue targets, however they are measured.
“Historically landlords have collected rent each quarter and haven’t had a deep relationship with their tenants,” DLA Piper partner Lorraine Reader said. “Now a landlord needs to view the relationship like a partnership and almost invest in the tenant’s business to make sure that each gets a share of the upside. They don’t have a lot of choice; it is difficult to pick up a newspaper in the current climate without seeing a story of a retailer in distress.”
To ensure a lease isn’t entirely in a tenant’s favour, landlords should build in flexibility, Reader said. Flexibility includes break rights if a business underperforms or the right to move the tenant to a different part of a shopping centre or street. Tenants are increasingly expecting that flexibility to be included, she added. New Look’s request for turnover leases included offering landlords the right to take back stores to re-let to other tenants.
Values Will Be Affected
Clearly, a widescale move to turnover leases will impact property values. How can a property be valued in the same way if instead of a 10-year fixed revenue stream it offers a collection of leases that can go up or down?
“Usually institutional investors look for a bond style income with rent each year,” Samuel said. “Now rent can fluctuate considerably. Asset values will therefore also vary. You would expect those assets to be valued more like hotels — it’s all about location and the business model.”
Without backing from lenders, a turnover lease model could lead to a long-term asset management challenge, DLA Piper UK Head of Real Estate William Naunton said.
“There are issues with how a landlord could finance a property if there is uncertainty,” he said. “If you have a reduced rent, how could you borrow money if a shopping centre needs capital expenditure, for example? Could we see retail units fall into disrepair?”
This is a worst-case scenario for retail: that property values fall to the extent that there is no financial incentive to carry out repairs or to improve a scheme. At this point, conversion to alternative use such as office or residential might be a more viable option.
On the flip side, if revenue boils down to the success of a store, landlords might be more incentivised to work with the tenant. As Reader said, “the upside is the creation of true partnerships between landlords and tenants”.
Ignoring the growth of revenue-based leases is not the way to deal with the situation, the DLA Piper team argued. We are likely to see far more CVAs and New Look’s move has already influenced other retailers.
Understanding the new lease model could spark a rise in the role of the expert asset manager, one who can help a retail store succeed. Landlords might also turn to technology, such as DLA Piper’s new platform Release that facilitates the digital asset management process, streamlining negotiations with tenants and ongoing tenant management.
“If a landlord understands turnover leases and is willing to negotiate within its own red lines, they will capture the market better and have better tenants,” Samuel said. “The question is, is this a pandemic trend or is it here to stay? There is probably a lot more stressed retail and CVAs to come.”
Lockdown provides an unreal situation for retailers and it is not possible to predict quite what the landscape will look like once the UK moves out of the global pandemic. Naunton predicted we can expect “continued supply and demand imbalance every time a lease event occurs and for the time being tenants will dictate terms”. No matter how the situation pans out, a landlord needs to determine its negotiating position today.
This feature was produced by the Bisnow Branded Content Studio in collaboration with DLA Piper. Bisnow news staff was not involved in the production of this content.