Turnover-based rents – a lifeline for hospitality?

In the wake of the Covid crisis and its devastating impact on the nation’s high streets, many UK landlords in the retail and restaurant spaces have moved from offering fixed leases to turnover-based rents, in order to allow struggling tenants to continue trading. Could the hospitality sector follow suit?

A traditional commercial lease has been characterised by five-yearly rent review cycles on an upwards only basis; and a term of at least 10 years, often rising to 20 or 25 for hospitality operators.

According to law firm Travers & Smith, landlords and their lenders have become accustomed to this structure. It facilitates a strong headline rent for valuation purposes, provides for a certain return and protects the landlord from changing market forces affecting the tenant’s business.

But when business collapses and the tenant is effectively or actually forced to cease trading, as has been the case recently, the limitations of this structure become apparent. No revenue eventually equals no rent.

So turnover-based rents are becoming increasingly popular. These function as a mechanism to reflect changes in market rent over time which removes the rent burden when trading is poor, but which allows the landlord some upside when times are better.

In the UK, particularly among the major London landlords, there has been a widespread acceptance, that for the short- to medium-term at least, this is the best way forward.

The Crown Estate, which owns a large part of London’s West End, has written to some of its tenants offering a switch to turnover-based rents. In one case it asked for nine per cent of turnover or a percentage of what it would normally receive in quarterly rents, on a scale starting at nought per cent for the current period, rising to 75 per cent.

Restaurant operators Corbin & King, whose Soho restaurant Brasserie Zedal is located on Sherwood Street, is one beneficiary of the offer, according to a report in the Sunday Times.

“For a number of our restaurant operators who are facing particular challenges at this time, we have offered the option to move to more of a turnover-based structure for the coming period on a case by case basis, as part of the safe and sustainable reopening of the West End,” said James Cooksey, director of the Crown Estate’s central London portfolio.

Cadogan, which owns 93 acres in London around Chelsea and Knightsbridge, is scrapping all base rents and moving to turnover rents until 2021. “Over the past few months, we have been working closely with our hospitality businesses – over 30 restaurants, bars and cafés – to remove all base rents and convert each to turnover-only rent until 2021,” said chief executive Hugh Seaborn. “We are doing everything we can to encourage a safe and sustainable return for businesses across the area. This extends the support package that we agreed and announced earlier on this year and means our financial support for local business has now extended to almost £15 million.”

The Howard de Walden Estate has also moved a number of hospitality occupiers to turnover-based rent agreements for the next 12 months. “Prior to lockdown, we were already reviewing our strategy for Marylebone Village to see how it could best meet the needs of retail and leisure businesses,” said Rob Kirk, the estate’s head of retail and leisure. “Since the pandemic hit, that process has had to accelerate. For some hospitality occupiers, we have agreed turnover-based rental agreements for the next 12 months and we continue to discuss options with others. Throughout this process, our key consideration has been to have an open dialogue with our retail and leisure occupiers and we will continue to do so during the coming months while we all work together to help Marylebone flourish.”

Other major landlords offering a switch to turnover-based rents include ShaftesburyCapital & Counties, and Legal & General.

The latter has gone as far as declaring the 1954 Landlord and Tenant Act unfit for purpose, highlighting that retail business launches and failures have increased by 29 per cent over the last five years, and in 2019 the average length of a new retail lease fell to under five years.

It has brought in a flexible partnerships model that it says will “bring optionality to occupiers from start-ups all the way to superstores”. It offers four different structures, from three-month ‘whitebox space’ leases aimed at startups to long leases for existing occupiers who require long-term security.

Denz Ibrahim, head of retail & futuring at LGIM Real Assets, said: “Demonstrating our commitment to bring innovation to the real estate sector, this new flexible partnership model really sets the bar for institutional landlords. It will provide optionality to all our existing and future occupiers in how they want to partner with us, and flexibility for us around who we want to work with. Our role as owner is shifting from what was solely ‘the librarian’ (collecting rent, renting shops and cleaning spaces), to becoming an ‘editor’ of the space. We need to ensure we have the right content, at the right time, in the right places, to support both occupiers and consumers. Understanding these changing behaviours and having more curatorial control over our assets allows us to be on the front foot in delivering future ready places, whilst helping our occupier weather the seismic changes impacting the retail and leisure sectors.”

If their landlords are not offering turnover rents, then tenants are beginning to demand them. Japanese restaurant chain Wasabi appointed KPMG to lead discussions with landlords to negotiate a switch to turnover-based rents. New Look and Pret a Manger have also asked landlords to share the pain of their drop in income by switching.

And BE Offices, one of the UK’s biggest flexible workspace operators, has said it will only sign turnover-based leases in future. Co-founder and managing director David Saul said: “The days of the conventional five-year lease are finished. We haven’t started acquiring new space again since lockdown began in March, but when we do, if landlords want us in the building, that’s what we’ll be requiring. You might agree a base rent and then a top-up rent based on turnover, a bit like what is going on in the retail sector. The way that operators will take premises has changed. I don’t think many operators will want to sign a conventional lease and pay quarterly in advance anymore.”

So the retail, restaurant and office sectors are all making the well-publicised switch to turnover rents, but until now there has been relatively little sign of the hotel and serviced apartment spaces – where fixed leases are prevalent, following suit.

But this could be starting to change. Goodnight Hotels is a new brand that has been launched in partnership with Village Hotels, in the wake of the Travelodge CVA. It is bidding to attract Travelodge landlords looking to exercise their break clause. It says the landlords of more than 50 hotels have expressed interest and expects to launch with at least 80 properties.

Village Hotels will provide the management and operational platform on a white label basis. Goodnight is offering three different lease structures, one of which is a base rent and share of turnover structure. It is aiming to have leases agreed by late September with a view to commencing trading in January 2021.

The turnover rent model is not a magic pill for the hospitality sector’s current maladies, and it is not without its issues. Ryan Smale, a solicitor at Irwin Mitchell says for some landlords a fixed income stream is used to finance acquisitions, pay dividends to shareholders, and cover their liabilities. He says turnover rents can “make these income streams more volatile and therefore harder to plan for the future”.

Turnover rents require a much higher degree of collaboration between the landlord and tenant. There needs to be a willingness from the tenant to share more financial and trading information than they have traditionally done, and they can result in a bigger administrative burden, compiling and presenting trading figures regularly.

But it should be a simpler matter for hotels and serviced apartments to calculate turnover than it is for retailers, who are already wholeheartedly embracing the concept. They have to factor in not only in-store sales, but online purchases, deliveries, click-and-collect, and so on.

Sue Shepherd, Realm’s general manager for London Designer Outlet, a shopping centre in Wembley, says turnover rents “create a symbiotic relationship between landlord and tenant. In good times, both parties benefit; in less favourable times, both have an incentive to seek improvements”.

In an environment where recovery is going to be slow and gradual at best, that sounds to me like a pretty good option for hotel and serviced apartment operators.

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