Empty retail properties "to let" on Richmond High Street in London, Sept. 24. The impact of the COVID-19 pandemic is expected to lead to many struggling retailers requesting turnover-based leases.
Source: Getty Images

Retail property was once a simple business — how times have changed. The COVID-19 pandemic has overturned much of what retail landlords and their tenants have long taken for granted.

Lockdowns earlier in the year to delay the spread of the virus left many retailers unable to trade, while continuing restrictions have badly damaged revenues in particular locations. Many have been unable to pay some or all of their rent. Retail landlords are faced with a market in which many of their customers are struggling to survive. Even if landlords wanted to evict them, some governments have placed temporary bans on them doing so.

But the dilemma posed to retail landlords by COVID-19 already loomed over many of them. If a large part of the retail sector is to avoid collapse, landlords must agree to rents that reflect what retailers can afford to pay. Struggling retailers argue some link must exist between the revenue a retailer brings in from the space it leases and the rent a landlord should expect from leasing that space.

Turnover-based leases appear to be the answer. "What the lockdown has done is put so much more pressure on the retail model that the move towards turnover leases has accelerated really fast," Dan Simms, co-head of U.K. retail agency at real estate services firm Colliers International, said in an interview. "But this is not just a sudden change due to the COVID-19 lockdowns, the market has been steadily moving that way for quite a few years."

Turnover leases — or percentage leases — have become increasingly common in many developed markets as the rapid growth of e-commerce, particularly in the U.S. and U.K., chipped away at the revenues of brick-and-mortar retailers, killing off many.

The pandemic is tipping many struggling retailers over the edge. In the U.K., 49 medium or large retailers have fallen into insolvency in 2020 through to early August, according to the Centre for Retail Research, just five off the record of 54 set in 2012. The insolvencies affect 3,140 stores, the largest number impacted since 2012.

Many retailers have been unable or refused to pay rent as a result. As of 60 days after the U.K.'s third-quarter rent collection day in June, retail landlords had collected 60% of due rent, according to commercial property data firm Re-leased. This compared to 59% collected 60 days after the second-quarter rent day in March.

Landlords are dealing with a surge in demands for revised rents that reflect the reality of occupiers' income. "What we're seeing now is an industrywide response across the entire sector calling for turnover rents due to nationwide store closures," Lauren Higgins, associate, Central London retail, at real estate services firm Savills, said. "It has given retailers the opportunity to push for a 're-setting' of rents and a new normality across the industry."

The response among landlords has been mixed. Some, such as European mall owners Klépierre and Unibail-Rodamco-Westfield, publicly ruled out moving to leases purely based on turnover. Others such as U.K.-based Hammerson PLC and Legal & General Group PLC have recently announced wholesale reform of their leasing model to reflect the current realities of the market.

Landlords have traditionally been reluctant to commit to turnover leases in the long term as they rely on the security of income, and valuations are still based on this model, said Tom Whittington, director, retail and leisure research at Savills. Landlords' views are unlikely to have changed despite the brave face some are putting on the shift, he added.

"The new agreements we have been seeing put in place over the last four months are not necessarily intended as a permanent fixture by landlords, but more of a way of navigating the current challenges in the sector," Whittington said.

Recent research by Savills found 74% of retail and leisure landlords see rent negotiations as a short-term solution of less than two years. The survey also found that 91% of U.K. retailers who responded had existing leases with a turnover provision, while landlords said only 10% of total retail and leisure leases are turnover-based, a disparity that perhaps suggests a reluctance among landlords to admit to how common the model now is. As much as 82% of retailers will be looking to re-gear some existing leases to incorporate a turnover provision in the future, according to the survey.

Not always the answer

Still, turnover leases are not a "one size fits all" solution, said Higgins. "This issue is largely location and retailer specific," she said. "We expect either turnover-based rents or a rebasing of rents to become more apparent, particularly in poorer trading locations."

Fashion retailers, whose stores have been among the hardest hit by e-commerce and whose turnover fluctuates due to seasonality, are among the tenants most likely to request leases with a turnover component. The model is also well-suited to leisure and food and beverage operations where the property's relationship to the turnover generated is more tangible.

Not all property assets are compatible with turnover leases. Shopping centers and retail outlets tend to be best suited as the landlord has influence and oversight on footfall and can collect turnover data more easily, while individual assets on high streets and city centers are less suited for the same reason.

The model is further complicated by the question around how much turnover a store actually generates in an "omnichannel" retail environment of showrooming and click-and-collect.

"This transition does raise a number of questions about how store turnover is calculated in the context of the total retail proposition," said Nick Gardner, executive director, head of advisory and transactions, U.K. retail, at real estate services firm CBRE. "The retailer also needs to acknowledge what the role of the physical store is in rental terms alongside click-and-collect, online returns, brand enhancement and the halo effect on online sales."

For landlords, the bottom line from turnover rents appears to be lower returns. But in a current retail climate of surging e-commerce growth, falling demand for space, and mass store closures, they have little option but to help keep their customers afloat, said Colliers' Simms.

"They should celebrate that they're doing these deals," he said. "It's a good thing that it is now openly out there that most people acknowledge we need to shift our market largely to this sort of model. Not all the time, but it needs to be one of the key drivers in making sure people stay trading."