In this two part blog, Jenni Guy and Danny George will consider turnover rent lease structures and some key considerations from both a landlord and a tenant perspective when negotiating turnover rent leases.
Whilst the principle is not new, turnover rent deals have more recently been implemented as a practical and sympathetic response to potential drops in turnover for businesses operating in the retail and leisure sectors, whether that be because of Covid 19, or the wider effects of e-commerce. The value to tenants is clear; they share a degree of commercial risk with the landlord by potentially paying more rent when times are good, but likely paying less during more challenging trading periods.
That said, it is important that landlords and tenants are aware of potential pitfalls when negotiating turnover terms.
Base rent + turnover or Turnover only?
There are different ways to structure turnover rent leases. In some instances, the rent paid is exclusively based on the turnover figure – a tenant will pay rent based solely on their trading performance.
In other circumstances there may be an agreed base rent (i.e. a fixed figure, usually below the open market rental value), which is then "topped up" by the turnover rent aspect. A landlord will be keen to receive rent as close to, or above, the open market rent level as possible.
A key landlord concern when considering turnover leases has always been certainty of income, particularly from a valuation perspective and when it comes to obtaining funding.
A base rent ensures that the rent received by a landlord does not fall below a certain minimum amount. If a landlord is confident of the tenant's covenant or the tenant is in a particularly strong bargaining position, a lower base rent may be agreed in exchange for a higher turnover percentage.
What does turnover include?
Both the landlord and the tenant should carefully consider what should and should not be included in the calculation of turnover.
Internet sales present a complex situation. If a customer visits the premises to view potential purchases and then orders the product online, is that a sale from or attributable to the premises? How can the connection be proven? It could be a share of online revenue perhaps limited to that which is generated within a certain distance of the premises. This could be argued to be a fair trade-off for a reduced fixed rent but the feasibility of this will depend on the nature and location of the store.
Online returns must also be dealt with as they can skew the figures for the shop in question, especially if detailed records are not kept as to whether the purchase was made from that shop or from the internet. One simple solution to calculating the value of online sales to be allocated to turnover could be to divide the turnover from internet sales minus the estimated total value of returns by the number of shops the tenant operates from time to time.
Payment of Turnover Rent
Turnover rent, by its very nature, is only payable in arrears i.e. once the turnover figures are known and so due dates for payment are an important consideration.
For tenants, if they are to benefit from a rent free period in respect of the base rent, they should ensure that the rent free period extends to turnover rent for that period. Otherwise, if the turnover rent is calculated after deducting the base rent and the base rent is nil because of a rent-free period, the amount of the turnover rent will be increased.
To protect against the risks of the landlord being due a large sum of turnover at the end of each turnover period, a tenant can be required to pay the base rent or, if there is no base rent, an on-account rent monthly or quarterly in advance. At the end of the year, there should then be a reconciliation against the turnover and any additional amounts due by the tenant paid. With turnover rent being payable in arrears, a landlord must ensure that they are entitled to recover the amount due at the end of the lease once the figures have been finalised by keeping the turnover rent provisions alive after the lease has ended.
Rent Review
Usually, a base rent will be reviewed five yearly with a deduction made based on the agreed % that it relates to the open market value of the premises. Turnover leases have implications for rent review and so a tenant must negotiate changes to standard rent review clauses. For example, the tailoring of restrictions on alienation and break rights to account for turnover should be disregarded at rent review as should the turnover provisions themselves. Failure to disregard these could result in an inflated base rent at review.
LBTT
Calculating land and buildings transaction tax (LBTT the Scottish equivalent to SDLT) payable by a tenant in respect of the grant of the lease is slightly more complex for turnover leases. Initially, the tenant must make a reasonable estimate of the rent payable for each of the years of the term of the lease. Any differences between the original estimate and the actual sums paid will then be picked up in the three yearly returns which the tenant must submit to Revenue Scotland. It’s also important to remember this on completion of an assignation as the incoming assignee should ensure that they have access to any historic information that may be needed as part of their tax calculations.
In this part one, we have focused on the "money clauses" which deal with turnover rent. In part two, we will look at clauses seeking to regulate trading performance and dealing with a change of occupier. Please contact Danny, Jenni or your usual Brodies contact if you would like tailored advice on turnover rents or leasing generally.
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