Anatomy of turnover rents in retail leases
A look at turnover rents – when they are used, how they work and what the pitfalls might be.
A turnover rent can be a very useful mechanism for setting a level of rent which is commensurate with the performance of the tenant’s business – particularly in a retail or leisure context. A turnover rent can be attractive both to landlords and tenants.
A tenant in a potentially uncertain new location or subject to potential trading crosswinds, such as retailers currently face, will be keen to ensure that its base rent is set at a manageable level and will then be willing to part with a turnover rent by way of top-up in circumstances where trade is good. The tenant remains incentivised to make the business a success (provided that the turnover rent is not set at a level which effectively disincentivises the tenant) whilst having the security of knowing that the rent is more manageable if business is slow.
The landlord, for its part, will also want the tenant’s business to be a success as it has a greater financial incentive in this scenario to make the location and surroundings as favourable as possible to increase footfall and dwell-time to help its tenant to maximise its return. This symbiosis is particularly evident in shopping centres and retail/leisure parks, where the landlord has control over the environment and ambience of the common areas. Tenant mix is critical – to attract compatible businesses to draw in customers while allowing avoiding excessive competition.
There are some broad principles around turnover rents which apply in most turnover rent clauses. These are:
- Minimum guaranteed rent. Usually, there will be a minimum level of turnover (and so turnover rent) below which the tenant is not to fall. This is usually based on a level of the turnover rent applicable at around 75 to 80% of the market rental value of the premises.
- Turnover rent. This is often expressed as a percentage of the gross turnover during a turnover period. This will often be calculated by reference to a formula and can be “slabbed” so that the percentage may increase at defined thresholds (similar to how UK income tax is calculated). In longer leases, tenants will want the threshold to be subject to review, in order to avoid the turnover rent equivalent of “fiscal drag” (i.e., a higher proportion of turnover rent becoming payable as the inflationary effect of generally increased turnover (over time) takes effect).
- Gross turnover. What is included in gross turnover – and what is excluded – needs to be clearly and carefully defined. For example, sales in a convenience store of items where there is no margin, such as stamps or lottery tickets, will need to be deducted. Online sales with aspects related to a physical in-store purchase need to be carefully considered, especially where the pickup is in-store rather than by home delivery. The sale of gift vouchers and the treatment of ‘returns’ also can be problematic.
- Turnover period. Often this will be the annual trading period of the tenant, but there can be other reasons to link it to the trading or accounting period of the landlord or for shortening the period so that the turnover rent is calculated on a quarterly or even monthly basis. Often the landlord will want access to the tenant’s POS system for the real time collection of sales data. The tenant will provide a turnover certificate following the end of each turnover period (which could be audited), on the basis which the turnover rent is calculated.
- Base rent and turnover rent payment. The lease will need to specify how the rent is payable. There ideally should be a regular quarterly payment of a base rent (usually the minimum guaranteed rent) with a turnover rent being payable as a top-up on following the end of each turnover period.
- Open book. Many landlords require full access to sale information and till rolls, to ensure transparency and to avoid manipulation of the figures. Good landlords use it as a way to identify underperforming tenants and to suggest ways to increase tenant profile or to improve sales performance (or to trigger the termination regime).
There are considerable complexities involved in the negotiation and drafting of turnover rents (and particularly the calculation formulae). Care and advice need to be taken to ensure that what is being proposed is both workable and drafted effectively. Our team of experts here at FSP are able to advise on the specifics – please contact Richard Higgs or Michael Higgin.