Turnover rent leases– Some of the issues

United Kingdom

In recent years there has been an increase in the number of retail and leisure units let on the basis, at least partially, of a turnover rent. It is not just in the factory outlet/designer mall sector but also a considerable number of both new and the more established shopping centres have turnover rent elements. Well known examples include the Capital Shopping Centre scheme at Lakeside and the Harlequins, Bluewater and the Mall at Cribbs Causeway.

Although considered a way of encouraging greater partnership between landlords and tenants (with the landlord sharing in a tenant's success or pain for a particular unit), there are a number of issues which both landlords and tenants need to carefully consider as part of their lease negotiations. These include:-

1. What should be included as turnover?

The answer from a landlord's point of view is all income relating to the premises. There is a fairly well settled definition of "Gross Turnover" used by the majority of landlords. It is not just income received for goods sold on the premises. It relates to all income from all activities generated from the premises.

The focus is on turnover and not profit. The tenants' expenditure is irrelevant although there are a number of routine deductions from turnover including VAT, staff discounts, the amount allowed on goods traded in and cash refunds for defective or returned goods.

Landlords need to be very careful in departing from the established norms. To allow any exception opens up the possibility of abuse (for example, if the landlord were to agree that income from certain types of products would not be taken into account in calculating the "Gross Turnover", then an unscrupulous tenant could seek to sell those products at a higher price than usual but give away free other products which would normally be taken into account when sold by the retailer (to take an extreme example the video is sold for £500 and the video recorder given away!).

A particular issue which tenants need to address is income from other occupiers of their unit. A number of standard turnover rent leases allow for "double counting" in that where the tenant is allowed to share occupation with concessionaires or franchisees, the turnover generated by that other occupier is treated as turnover by the tenant for the purposes of calculating the turnover rent. In addition the rent paid by the occupier to the tenant is taken into account.

2. Internet Sales

If landlords are relying on turnover from individual stores then anything which affects the level of turnover could reduce the amount of the turnover rent. However, most turnover rent leases do not try to deal with this. The definition of "Gross Turnover" normally incorporates orders solicited by people reporting to or operating from the premises but how can you say that a sale made from a retailer's individual website is in any way related to or originates from specific premises?

The full impact of internet sales has yet to be proven. Clearly there are some retail operators who because of the nature of their business are likely to generate more substantial sales over the web than others.

If the landlords are concerned about this, what can they do? There are a number of potential alternatives including:-

  • Changing the definition of "Gross Turnover" to include income from products delivered by the retailer to premises within a radius of, say, 20 miles of the relevant store. This would however be purely arbitrary. How can you say that the sale is as a result of the presence of the store? It would also be virtually impossible for the landlords to monitor retailer’s own internet sales.
  • The percentage of turnover payable in each case is a matter for negotiation and varies for each different retailer. There is nothing to stop a landlord negotiating a higher turnover rent percentage than the landlord would normally seek where the landlord is concerned that the retailer would generate less in terms of turnover from a particular store as a result of its e-tailing operation.
  • As an alternative any landlord who was particularly concerned could try to negotiate arrangements whereby it receives x% of the turnover generated from the store plus y% of the overall internet sales for the particular retailer. But why should the retailer agree this and, again, how could a landlord monitor those internet sales?
  • It has been suggested that the landlord should set up a website for each retail scheme where the goods of the individual retailers who trade from the scheme can be purchased over the web and with the landlord receiving a percentage of the turnover of the internet sales of each individual retailer from that web site. However, apart from being expensive to establish, it is more likely that any potential internet customer will be looking for the website of an individual retailer rather than recalling the particular retail scheme that the operator trades from and accessing the website for that scheme.

If internet sales are to generally be ignored, it does mean that landlords can completely ignore e-tailing itself. As mentioned earlier deductions are often made for returned goods. It is important there are no deductions in respect of goods returned which have been acquired initially over the web. Deductions should only be made for returned goods which were originally sold from the relevant premises.

3. Assignment

The tenant mix is crucial to the success of any turnover rent scheme. Any landlord is therefore looking for far greater control than usual over alienation. Underletting would normally be completely prohibited (although in some circumstances underletting of part may be allowed depending on the size of the unit and the proposed use).

Therefore there are usually greater restrictions on assignment. There are a number of different approaches including:-

  • Assignment could simply be prohibited.
  • On assignment the rent payable could simply revert to an open market rent. If the turnover rent leases are the traditional 80% of the open market rent in any event this will simply be a mathematical calculation. Tenants should however watch for the implications if the leases require that a then open market rent needs to be calculated at the time of the assignment. Provisions requiring the agreement or third party determination of that rent before the assignment can be completed could delay the assignment. If the new rent can be calculated subsequently, can an assignee be persuaded to formally complete the assignment when there is uncertainty over the level of rent?
  • A number of leases include a right of pre-emption so that the tenant has first to offer to surrender the lease back to the landlord before assigning to a third party. If the relevant lease is not excluded from the Landlord and Tenant Act 1954, these rights of pre-emption lead to a stalemate in the event of either party failing to complete the surrender – an agreement to surrender is not legally enforceable without a prior court order. Landlord's take different approaches as to if, and when, to obtain a court order. The lease should still permit the tenant to assign where the landlord defaults in completing the surrender. In any event the tenant should also make sure that these rights of pre-emption do not apply when the tenant is disposing of a number of stores as part of a sale of it's business.
  • Sometimes coupled with the right of pre-emption you see provisions for the turnover rent to be suspended for a period of, say, one year from assignment. The idea is that each retailer operates from very different margins and turnover levels and the turnover percentage is to some extent personal. You should therefore suspend the turnover rent for a year and the rent should revert to 100% of the open market rent during that period. At the end of that first year's trading a new turnover rent percentage is calculated with provision for a third party to settle any dispute.

At all times landlords and tenants need to remember the potential rent review implications of the assignment restrictions and these should be disregarded where relevant.

4. Other issues/traps for the unwary

  • Rent free periods:

    point often missed by tenants is that where they have a rent free period in respect of the base rent this should apply equally to the turnover rent. Otherwise if, as is usually the case, the drafting of the lease envisages that the turnover rent is calculated after deducting the base rent and if the base rent is nil because of a rent free period, the amount of the turnover rent will be increased.

  • The Landlord and Tenant (Covenants) Act 1995:

    Where the current tenant is in arrears of rent under a turnover rent lease and the landlord wishes to claim the arrears from a previous tenant, the landlord needs to remember that the previous tenant will have a statutory right to a new overriding lease on the same terms as then currently subsisting. This will include the turnover percentage and landlords need to think carefully about which former tenant they demand arrears from (assuming they have a choice).

  • Keep open covenants:

    Where the landlord is relying on turnover for part of its rental income, the keep open covenant becomes even more important and a lease should provide for liquidated damages to be payable for breach. In order to be enforceable liquidated damages need to be a genuine pre-estimate of the likely losses. An approach is simply to say the liquidated damages are a multiple of the base rent (ie where the base is 80% of open market rent liquidated damages are 1.25% of the base rent so that the landlord then receives 100% of the open market rent).

There are advantages to encourage greater partnership between landlords and tenants by use of turnover rents but all parties need to be aware of some of the more substantive issues which need to be addressed. Most of these issues can easily be dealt with during the lease negotiations but it is important that landlords and tenants properly address the issues at that stage.

This article was first published in Estates Gazette. For further information please contact Mark Heighton on +44 (0)20 7367 2177 or at mark.heighton@cms-cmck.com.