Are we seeing the end of the traditional commercial lease? Even before the arrival of COVID-19 there has been increasing disquiet over the perceived ‘onerous’ nature of commercial leases. The rise and rise of online shopping and the changing demands on the retail, restaurant, supply, logistics and manufacturing sectors have led tenants and, increasingly, landlords to view much of the 1954 (Landlord and Tenant) Act as being obsolete and in reality an obstruction to a dynamic property market in the modern trading environment.
Whilst is it tempting to view the problems of the retail sector, in particular, as a stand-alone problem that doesn’t really affect the rest of us, one should remember that pension funds have huge investment interests in commercial property funds. If the flow of rents declines and the properties themselves lose intrinsic value, then the ability of those pension funds to pay the pensions they were set up for starts to become questionable. That really should alarm a few people!
COVID-19 has now exacerbated what was already a market in crisis. With the restrictions from social distancing meaning shops’ and restaurants’ scope for trading at maximum customer footfall/covers is hugely diminished and the usual calculations of floor area and rental value are irrelevant. That situation is not likely to change anytime soon. And if tenants are entitled to renew their leases and indeed want to do so on what basis are they entitled to review the rents to a level which is sustainable by it and indeed tolerable to its landlord? So, is there a way forward? Can the current problems be fixed?
rhw’s commercial property team provide advice to a wide range of clients, some of which are in the retail and restaurant trade. Our team have been looking at the viability of turnover based leases as a way of addressing the changed trading conditions. The idea of a turnover based lease is not new but they have, up to this point, never really gained traction in the property markets generally although they have proved to be a workable solution in limited circumstances. Some of that is down to the fact that they potentially provide less income to landlords and investors and the fact that future rental income is harder to forecast.
However, the upside is that if, for example, you have a restaurant that in normal times would provide 60 covers but the COVID restrictions mean that you can only serve 30, then the lessee would be able to say the property rent should be based on the actual income stream that is able to be achieved in the present market conditions, rather than the fixed rental assessment that the current lease arrangements provide.
It sounds simple on paper but there are difficulties that will have to be dealt with. Initially, how would a retailer or restaurateur prove that the current achievable turnover is X amount without tangible income records to refer to? Landlords are also likely to resist leases purely based on turnover due to the risk and uncertainty factors.
There are some sectors that have already been using the turnover based lease model. Factory outlet centres adopted this lease type some time ago. Whilst it gives tenants some flexibility, it has also given the landlords a benchmarking ability to control who they accept as a tenant, by building financial models that calculate what are achievable turnover levels for certain types of retailer in certain locations.
What happens in reality, more often than not, is that some sort of hybrid model is adopted which has a base rent in place to give the landlord some reassurance but an upper level of rent based on a percentage of the turnover performance of the tenant. The turnover and footfall performance can also allow break (or forfeiture) clauses to be triggered for both the tenant and possible the landlord, which will give some reassurance to those worried about being stuck with a lease in deteriorating trading conditions and for landlords who have a tenant who is not performing as they should be in the location they are in (compared to others nearby).
The trading conditions for many sectors of the market are changing at a dynamic rate. Something will need to happen to the way leases are dealt with to prevent wide-scale voids appearing on the high street, in shopping centres and elsewhere that will be bad news for jobs, customers, business and pensions. How quickly the change is adopted is likely to be forced by pure necessity of filling property units and keeping rental income flowing.
By Jack Lightburn.
Please contact rhw’s Commercial Property Team for more information on this article or for legal advice on any other commercial property matter.