The current financial crises has seen many businesses struggling to manage regular cash flow, which may be the case for some time.
Rent is one of the main outgoings for commercial tenants and in a standard market rent lease, reviews are usually ‘upward only’ and do not take any account of the tenant’s profit and success. In contrast, turnover rent is calculated by reference to the turnover generated at the property.
Turnover rent is not a new concept and has been used across the retail and leisure sector for many years, however more recently it is becoming popular in mainstream commercial property leases as a solution for providing a shared risk/reward model between landlord and tenant.
Here we’ll consider turnover rent in more detail as an option for landlords and tenants to weather economic uncertainty. And remember, our commercial lease solicitors can help guide you in negotiating and drafting a fair and practical lease agreement.
Contents:
What is a turnover rent lease?
A tenant pays a percentage of their turnover rather than a fixed or monthly annual sum to their landlord. Turnover rent usually forms only part of the total rent payable. There is usually an agreed base rent which is then topped up with an agreed percentage of the tenant’s turnover. The agreed base rent ensures that the rent received by the landlord does not fall below a certain minimum amount (for example 75-85% of market rent).
Turnover rent is usually based on gross turnover rather than profit. Profit is calculated by deducting overheads and results in a lower figure than gross turnover. Profit can also be difficult to monitor.
There are two types of traditional turnover models: the base and turnover model (which includes a base rent regardless of the tenant’s turnover), and the turnover only model.
What are the pros and cons for landlords and tenants?
Advantages
- Tenants’ overheads reduce in difficult trading conditions
- Landlords receive some rental income rather than have vacant premises
- It spreads the risk between the parties. In times of recession, turnover rent leases provide landlords with the potential for increased income if the tenant performs well or the market picks up, while passing on the responsibility for rates and other charges to the tenant.
- Existing tenants can remain trading and in occupation in times of market downturn.
Disadvantages
- They can lead to complicated disputes if not properly and clearly drafted
- Turnover rents are complex to manage and impose an administrative burden. Turnover can be difficult to classify or prove
- A poorly performing tenant business can affect the value of the property
- Landlords may need to get approval from their lender
- Lenders taking the risk of turnover rents that may fall below open market value may require landlords to apply increased turnover rents to repayment, or part repayment, of the debt
- Landlords or their lenders may require a landlord's break right if the tenant underperforms for some time
- Landlords must face periods where the rent is lower than the market rent
- Landlords may prefer a traditional market rent model over the uncertainty of turnover rent, particularly where they are dependent on finance.
How is turnover calculated?
Turnover rent is based on a percentage of the tenant’s gross turnover at the property. Usually, the tenant pays a base rent which represents a discounted market rent, plus a top up based on a fixed percentage of gross turnover for the year. The turnover period is usually annually and in line with the tenant’s business accounting year.
The rate of turnover percentage may be fixed or “staircased” at certain levels. There may be capped (maximum) and collared (minimum) liability, or variable rates. These are matters for negotiation in each case.
The tenant may want to pay turnover rent annually in arrears and the landlord would still typically receive the base rent quarterly in advance, as is common in a market rent lease.
Definition of turnover
Parties must define what is included in the definition of gross turnover. The following amounts are generally included and can be tailored as required to the tenant’s specific business:
- consideration received for
- goods (or services) sold or performed
- goods hired, leased or otherwise disposed of
- all business carried out.
- consideration received from orders
- charges made by the tenant for delivery, insurance or postage services
- deposits not refunded to the customer
- sums received from sales of service contracts, guarantees and extended warranties
- the full sale price of any goods or services sold on a credit, instalment, hire purchase or lease purchase basis even though the tenant has not received full payment.
The inclusion of other amounts varies on a case-by-case basis. The tenant will want to only include the sums actually received, rather than sums receivable. Landlords may resist this as they will not want to lose rent due to the tenant's bad debts or because customers have not paid instalment payments to the tenant. Normally VAT is expressly deducted.
How could turnover rent clauses effect other provisions in the lease agreement?
Permitted use: The landlord may want to exercise greater control over the permitted use of the property to ensure that it is generating a turnover.
Confidentiality: The landlord may not want to make the turnover provisions available for public inspection at the Land Registry and the lease should then include an obligation on the tenant to apply to designate the lease an exempt information document when applying to register the lease. Tenants may also want confidentiality provisions to restrict how the landlord can use information provided by the tenant and its disclosure to others.
Keep open covenants: Landlords may want to include a keep open clause to prevent the tenant from restricting the trading hours at the property, which could impact on the rent payable. A landlord may be entitled to damages for the breach of that covenant.
Rent-free periods and rent suspension: If drafting a rent-free period in the lease or allowing rent suspension in certain circumstances, the parties need to consider whether this should cover both the turnover rent and the base rent.
Rent review of main rent: If the lease is not short term, typically it contains provisions for reviewing the base rent periodically. When drafting a rent review clause in a turnover rent lease, the hypothetical lease should look like a traditional market rent lease.
Alienation: It is common for turnover provisions to be personal to the original tenant. It is also standard practice not to permit underletting where a lease includes a turnover rent.
Break clause: If the break date does not match the date of the turnover certificate, the landlord may require an upfront payment (based on an estimate of the outstanding turnover rent) or provision of the turnover certificate as a condition of the break.
Forfeiture: If the rent is made up of both base rent and turnover rent, the landlord will want to make sure that the drafting specifically includes the right to forfeit for non-payment of either or both.
Can turnover rent be temporary?
In pandemic trading conditions, a landlord may choose to accept full turnover rent on a short-term basis where the tenant cannot afford to pay a fixed minimum sum, or they may accept a basic rent and a “top slice” of turnover income for a comparatively longer period, and this could be subject to arrangements for early termination and reversion to a full market rent basis.
There could be a landlord option in the lease to terminate top slice turnover and to revert to a full open market rental basis in specified events, for example after a fixed period (having allowed time to assess the average returns of turnover income) or after a period of non-trading, or assignment or underletting. During a period of non-trading, there might be provision for payment of the full market rent or reduced rent.
During the lease term there is a choice of varying the lease by a formal substitution of turnover rent provisions by deed or agreement of variation, or for a letter of concession from the landlord accepting a turnover rent and setting out the terms permitted while the concession is to operate.
Turnover rent and tenant insolvency
A company voluntary arrangement (CVA) is a very flexible insolvency procedure. It is used by insolvency professionals to restructure struggling businesses with the intention of restoring them to being successful. Once approved a CVA binds both known and unknown creditors.
A feature that was not as commonly seen in the Landlord CVAs prior to the onset of the COVID-19 pandemic was an entirely alternative rent model arrangement being implemented by a CVA - such as a switch to turnover rents.
In most CVAs where the basis of calculating rents is moved to a turnover based model, there is usually at least some proportion of base rent payments provided to landlords.
Next steps
We recommend seeking legal advice at the outset of negotiating heads of terms, so that you understand the implications of different options and that the key terms can be clearly captured at the heads of terms stage. For further assistance, take legal advice from our commercial property solicitors.
