For many commercial tenants, rent makes up a big chunk of their regular expenses. This, combined with the current economic landscape, means lots of businesses are having a tough time trying to stay afloat while managing day-to-day finances.
In a typical commercial lease, rent very rarely decreases. Usually, the opposite happens. Nor do they consider how well the tenant is doing financially. Enter turnover rent leases.
Turnover rent leases aren’t a new idea. They're frequently used in retail and leisure leases. But recently, they’ve been gaining traction in other commercial leases too because they work by tying the rent amount to how much money the tenant makes from the property.
In this article we'll explore:
What is a turnover rent lease?
A turnover rent lease is a type of commercial lease where, instead of paying a fixed or monthly amount to the landlord, the tenant pays a percentage of their turnover.
Usually, landlords and tenants agree on a base rate, which is a minimum guarantee for the landlord (e.g. 75-85% of the market rent). Then, on top of this base rent, the tenant adds a percentage of their turnover.
How do turnover rent leases work?
With a turnover rent lease, how much a tenant pays in rent goes up with their sales increase. But, if the business struggles and sales go down, the rent decreases.
How is turnover rent calculated?
Turnover rent is a percentage of the tenant's sales at the property, with the rate negotiated between the landlord and tenant. This rate can be fixed or adjusted at specific levels based on their agreement.
In these leases, tenants often pay the base rent every quarter and the turnover rent once a year.
This arrangement suits how tenants manage their business finances, providing them with flexibility. Simultaneously, it ensures landlords receive a consistent income throughout the year, helping them cover their ongoing expenses.
What is margin based rent?
Margin based rent is when rent amounts are calculated based on profit margins.
A key consideration in this kind of arrangement, however, is that two retailers might sell the same amount but their profit margins may be very different.
For example, Store A has a high turnover of £100,000 per month but its profit margin is relatively low at 5%. With a turnover rent agreement, Store A would pay a percentage of its £100,000 turnover, which amounts to £5,000. Despite the high turnover, the low profit margin means Store A’s rent payment would also be relatively low.
In contrast, Store B sells luxury watches with a turnover of £50,000 per month. However, because of the high margins associated with luxury items, Store B enjoys a profit margin of 20%.
In a turnover rent agreement, Store B would pay a percentage of its £50,000 turnover, which amounts to £10,000. Despite having half the turnover of Store A, Store B’s higher profit margin results in higher rent payments.
What is turnover?
For a turnover rent lease, both parties need to agree on a definition of ‘gross turnover,’ which typically includes various income sources tailored to the tenant’s specific business needs, such as:
Revenue from sales
While tenants may prefer to include only received sums in their definition of gross turnover, landlords may want to include owed amounts too, to avoid losing rent due to unpaid debts.
Generally, VAT is subtracted from the total of the calculated gross turnover.
There are no hard and fast rules on the definition of turnover, instead, landlords and tenants must agree on what constitutes turnover in their turnover rent lease to avoid disagreements in the future.
How do tenants prove turnover?
Proving turnover for a turnover rent can be tricky, therefore it's a good idea for landlords and tenants to agree on how it will be proved to avoid disputes.
This usually involves basing the rent on the previous accounting period or having the tenant provide a turnover certificate. That being said, other methods may be discussed which rely on trust between the landlord and tenant.
Regardless of the how, turnover rent lease agreements must detail how this process will work.
What are the benefits of turnover rent?
Turnover rent leases offer some benefits, especially in challenging economic times:
Tenants save on costs, keeping their businesses running during market downturns.
Landlords benefit from steady income instead of empty properties and can earn more if the tenant's business grows or the market improves, while tenants handle rates and charges.
Negotiating a turnover rent can be a lifeline for struggling tenants making them very appealing during challenging trading conditions.
Similarly, landlords who face the prospect of leaving their unit empty may choose to utilise turnover rent leases after coming to the conclusion that some income is better than none, especially given the mass exodus of businesses from the high streets caused by online retailers and, in part, the Covid-19 pandemic.
What are the disadvantages of turnover rent?
While turnover rent leases have some benefits, they also come with challenges and risks.
Some of the disadvantages associated with turnover rents include:
An increased likelihood of disputes between landlord and tenants if not clearly drafted or managed;
Extra admin for both sides, especially relating to record-keeping and admin for keeping track of turnover;
Difficulties in accurately identifying revenue sources and calculating turnover;
Risk to the landlord’s financial position if tenants don’t do well financially;
Risk to lenders if turnover rents don’t cover debts;
Uncertainty caused by rent fluctuations.
How do turnover rent clauses affect other provisions in the lease agreement?
Understanding how turnover rent clauses affect other provisions in the lease agreement helps both landlords and tenants anticipate and address potential future problems that may arise throughout the lease term.
For example, landlords may be more want more say in how the property is used given the amount of rent they receive is dependent on the business generating turnover. Other effects include:
Landlords may want to keep turnover rent agreements private and not want information available to the public via the Land Registry. If so, the lease should require tenants to label it as confidential when registering.
Tenants may also want confidentiality provisions to control how landlords use their financial information, especially to make sure their business strategies and performance data aren’t shared without permission.
Keep open clauses
Landlords may consider a “keep open” clause to ensure that tenants keep regular business hours. This clause stops tenants from closing their businesses or restricting trading hours, which could impact the amount of rent payable to the landlord.
For example, if a retail store within a commercial property closes or shuts down on certain days, it could result in lower foot traffic and reduced sales.
If a keep-open covenant is breached, landlords can seek damages from the tenant to compensate for financial losses. These damages could include the difference in rent that would have been earned if the tenant complied with the clause. Additionally, landlords may also have the right to terminate the lease or take other legal action against the tenant for non-compliance with the terms of the agreement.
Rent-free periods or rent suspension clauses are sometimes included in commercial leases to incentivise tenants to sign the lease agreement, or to allow them to temporarily pause or reduce their rent payments in certain circumstances.
When considering rent-free periods or rent suspension with a turnover rent clause in play, landlords must consider if they will waive both the turnover rent and the base rent.
This should be carefully worded in the lease agreement to avoid any confusion or possible future disagreements.
Periodic rent reviews
Periodic rent reviews are common in commercial leases and are used to make sure that the base rent reflects current market conditions.
When drafting a rent review clause in a turnover rent lease, it should mirror the structure of a traditional market rent lease where the rent is based on fixed amounts rather than turnover percentages.
This approach establishes a clear framework for determining base rent during rent review periods, promoting stability and confidence for both landlords and tenants over the lease term.
Alienation provisions govern the transfer of leasehold interests from one party to another, and they often reflect the unique nature of turnover arrangements.
It’s standard practice to restrict underletting or subleasing in turnover rent leases. This restriction helps maintain the integrity of the arrangement by ensuring that the financial performance of the business directly occupying the premises is accurately reflected in the rental payments of the landlord. Introducing additional parties through subletting could complicate the relationship and make it difficult for the landlord to assess the true turnover generated by the premises.
By restricting underletting and keeping turnover provisions personal to the original tenant, landlords can manage their risks and maintain control in the lease agreement, particularly concerning finances.
Break clauses allow the landlord or tenant to terminate the lease early under certain conditions. However, in turnover rent leases, it’s important to ensure that the break date aligns with the turnover certificate date.
If the break date doesn’t match, landlords may request an upfront payment from the tenant based on an estimate of the outstanding turnover rent. Alternatively, landlords may require the provision of the turnover certificate as a condition of the break to make sure that any outstanding turnover rent obligations are settled before the lease termination.
In leases where rent is made up of both base rent and turnover rent, landlords must make sure that any forfeiture clause in the lease covers non-payment of both types of rent. This means, if the tenant doesn’t pay either the base rent or the turnover rent, the landlord has the right to forfeit, or terminate, the lease.
The inclusion of this provision safeguards the landlord’s interests by providing a legal remedy in cases of non-payment.
Can turnover rent leases be temporary?
In tough times, landlords may adjust leases for tenants who can’t afford a fixed rent. For example, they might:
Accept full turnover rent on a short-term basis, where the tenant pays a percentage of their sales rather than a fixed sum;
Agree to a basic rent along with a portion of the income (known as a ‘top slice’) over a longer period, including provisions for early termination and referring to a full market rent basis.
A landlord may include the option to terminate the ‘top slice’ turnover arrangement and return to a full market rent after a fixed period, allowing time to evaluate average turnover income, assignment, or underletting. In cases of non-trading, provisions may be made for payment of the full market rent or reduced rent.
Variation of the terms of a turnover rent leaves can be done by a deed of variation, or the landlord may issue a letter of concession, which formally accepts turnover rent and outlines the permitted terms for the duration of the concession.
Company Voluntary Arrangements and Turnover Rents
Before the pandemic, it wasn’t common for struggling businesses to change how they paid rent to landlords under a Company Voluntary Arrangement.
A Company Voluntary Arrangement (CVA) is a plan that helps struggling businesses get back on track. Once everyone agrees to the plan, it impacts everyone the business owes money to, even if they didn’t know about it before.
Now, more businesses are trying out turnover rent lease agreements to manage rent if they are under a CVA. For landlords in this situation, the benefit for them is that they still usually get some of the rent payments they would expect.
Can turnover rents be used for multiple sites?
Turnover rents can be used for multiple sites, however, landlords and tenants need to be aware that calculating turnover for multiple sites can be more difficult. For businesses with many units, or an online presence, figuring out which store gets credit for each sale isn’t easy.
Making turnover rent agreements work for multiple sites means both landlords and tenants must have a good understanding of the tenant’s business and the landlord’s expectations.
As with anything in life, good, clear communication is key!
How to negotiate a turnover rent lease
Negotiations are part and parcel of thrashing out a commercial lease, and turnover rent arrangements are no exception.
To best hammer out the lease details, landlords should have a good grasp of the tenant’s business model to make an informed decision and understand what provisions may be necessary to manage any risks involved.
As well as this, both parties should be on the same page as to which type of turnover lease they are committed to, how long it will last, how turnover will be proven, and how they will go about settling disputes if they arise.
As with any negotiation, forewarned is forearmed, so both parties should take steps to understand the other position and the risk they could be taking on. In some cases, it may be worth consulting with a commercial property solicitor when drafting or negotiating these kinds of leases to ensure clarity and transparency.
How can we help?
If you’re considering a turnover rent lease agreement, it’s important to seek professional advice early on to make informed decisions.
Poorly worded lease agreements can have expensive, wide-reaching consequences, therefore it’s highly recommended to get help from a commercial property solicitor who can make sure the wording is clear, help negotiate or suggest terms, and clearly define key terms before any agreements are made.
For further help and a free case evaluation, contact our legal assessment team today.