One of the many consequences of the COVID-19 pandemic will be the long term effect on the landlord and tenant relationship. The concept of a landlord who passively collects rent on the basis of a 10-year (or more) lease term with an upward-only open market rent review at year 5, was being questioned in terms of long-term sustainability a while before the pandemic took hold. For many asset classes (particularly retail and offices), tenants now require greater flexibility, and COVID-19 has accelerated this requirement. One solution that tenants are looking to is turnover rents, but are turnover rent leases really a workable solution for landlords and their lenders, and will we see them being adopted heavily in the future?
What is a turnover rent?
In simple terms, a turnover rent is a rent that is calculated by reference to the income and other receivables generated at the leased property (usually on an agreed percentage of turnover basis). Historically, turnover rents have been seen in the retail sector, where it has been common to set a fixed level of basic rent (often as a percentage of open market rental value at the time of the grant of the lease), with a turnover element payable in addition. But what if this model was to change, so that the fixed level of basic rent was very small (or non-existent), and what if the model was to be rolled out to other asset classes (such as logistics, hotels, or offices)?
Downside for Landlords and their lenders
Landlords (and their lenders) will identify certainty as a key factor when modelling their investments, and certainty has a positive impact on both property values, and the pricing of debt. Indeed, where lenders need to underwrite debt on the basis of operating businesses (such as hotels), they will look at both historic and predicted trading data, which carries less certainty than fixed rent leases, and so the debt is typically more expensive. Likewise, turnover rents are by their nature uncertain, and have therefore always been relatively unpopular for landlords and their lenders. Two things have helped cement the unpopularity of turnover rents – (i) the "turnover" element of the rent is often not triggered, especially where base rents are set as high as 80% of open market rental value; and (ii) tenants historically have only ever pushed for the wide-scale introduction of turnover rents in a depressed market. However, a turnover lease can be drafted to include landlord-friendly provisions, such as any one or more of the following:
- a landlord’s break option, so that a landlord can terminate the lease if the rents are too low and they can replace the current tenant with a stronger prospect;
- a "success" payment for the landlord – whereby the percentage of rent payable to a landlord increases, or a landlord is entitled to a one off payment, if turnover for any given period is above a specified threshold;
- a "look back" period in which a balancing rent is due if turnover rent paid through that period hasn't reached a certain level (this is sometimes structured as part of the fixed level of basic rent, mentioned above);
- a prohibition on assignment –whilst the landlord may have been happy to enter into a turnover arrangement with the day 1 tenant, a landlord may not be prepared to be under an obligation to act reasonably when consenting to a turnover arrangement for an incoming assignee. Alternatively, the assignment provisions could require that the rents switch to "open market" after an assignment;
- "keep open" requirements and performance criteria (although we note that a "keep open" covenant, being a contractual obligation imposed by a landlord on a tenant in a lease to keep the demised premises open during certain specified hours, need to be carefully drafted and can be difficult to enforce); and
- (particularly appropriate for the retail sector) specified fixed rents on any days in which the property is not open to trade and should have been.
For any turnover rent lease to operate effectively, landlords require access to a wide range of income and revenue based information to support the turnover calculations provided by the tenants. Tenants will likely require stringent confidentiality obligations on their landlords not to share this information (although landlords will of course require carve-outs to these confidentiality obligations, most notably the requirement to share the information with their lenders). Equally, turnover rent leases include a number of commercially sensitive provisions (base rent, turnover thresholds, methods of calculation etc) that landlords may not wish the wider market to be aware of – for example, it will not be every tenant that a landlord is comfortable to offer a lease with minimal or no base rent. If a lease is registrable at the Land Registry, the agreement for lease and / or the lease should include a mechanism for the parties to agree and prepare a redacted form of lease (an EID or Exempt Information Document lease) to register at the Land Registry.
How is "turnover" calculated?
This will be crucial to ensuring that a landlord and its lenders are comfortable with the Lease, and as with any other provision of a Lease, a loan facility will need to contain a provision preventing the landlord (as borrower, or obligor) from amending or waiving the turnover rent obligations without the lenders’ prior written consent. Historically, in a retail context, "turnover" would constitute monies taken by the retailer through physical sales from the leased premises. Now, it is necessary to prescribe a much broader definition, to include online orders directed to the leased premises, and click-and-collect orders placed remotely, but collected in store. Tenants will be keen to exclude anything which does not have a direct nexus to the leased premises in question, and the treatment of gift vouchers, returns, partial payments and staff discounts will need careful consideration and negotiation on a case-by-case basis.
In the retail context, there are at least tried and tested precedents for turnover rent calculations. But what about offices, warehouses or industrial units? It may be possible to look at gross revenues or EBITDA from an operating business, but if a business is not a standalone enterprise operating out a single location, the parties will need to carefully negotiate how "gross revenue" or "EBITDA" is to be calculated and apportioned for the purposes of defining a fair and equitable turnover-based rent. Likewise, if the income available to the landlord is premised on a turnover basis, lenders are likely to want to underwrite their loans and set their covenants on the basis of revenues and EBITDA of the tenant operation (or the proportion thereof payable to the landlord). This is a very different underwriting premise than simply looking at the creditworthiness of the tenant and modelling a loan on the basis of ability to pay a fixed rent. In our view, it is likely to take lenders quite a while to get comfortable with such an approach, and pricing such loans will likely be increased accordingly, at least in the short to medium term.
And then there are hotels. There is already a tried and tested approach to sizing income-based covenants for hotel loans on the basis of EBITDA, but typically, the lender is either funding the entity that is directly entitled to that EBITDA (the SPV owned by the hotel investor), or it is funding the propco aspect of an opco-propcostructure whereby the propco is entitled to a fixed rent from that EBITDA-generating SPV. A loan to a hotel propco underwritten on the basis of a turnover based income stream is much rarer.
Getting Lenders comfortable with funding a turnover based income stream
In the short to medium term, we think that lenders will require additional credit support in order to get comfortable when underwriting a turnover based income stream. This could consist of any one or more of the following:
- Guarantees - a guarantee from the financial sponsor (or an otherwise heavily capitalized entity within the borrower’s corporate structure) which will top up the turnover rent receivable by the landlord to a minimum threshold (we would expect requests for such a threshold to either be a fixed level, or to be at the open market rental value threshold from time to time);
- Reserve accounts - a day 1 deposit of funds into an interest or debt service reserve account, controlled by the security agent, and releasable to the lenders in the event of there being insufficient income to service the debt, or to pay down the loan in the event of a financial covenants breach;
- Security over parent company guarantees provided to the Landlord - the lenders would require the landlord to procure a parent company guarantee in respect of the turnover rent-paying tenant, and would take a security assignment over the benefit of that guarantee. There would unlikely be any corporate benefit to the tenant’s parent company providing the guarantee directly to the landlord’s lenders, so this would not be a workable solution; and
- Success payments – any success payment payable to the landlord by a tenant (where turnover exceeds a specified threshold - as mentioned above) would need to be applied in immediate mandatory prepayment of the loan.
In terms of the landlord and tenant relationship, the problem with both items 1 and 2 above is that the risk of the tenant’s poor performance is well and truly in the landlord’s court, with the landlord (and not the tenant) needing to provide a bankable solution to the turnover rent arrangement. This is likely why the UK market has not seen more turnover based rents to-date. But with the ever changing landlord and tenant relationship, and the increasing need for certain businesses to have increased flexibility on rents in order to thrive (or even survive), we think the market will see an uptick in turnover based rents in the remainder of 2020 and beyond.