What impact will Covid19 have on rents?

As the fallout from the pandemic takes its toll on the property sector, £1.5bn of March rent payment remain unpaid in UK commercial property. Savills analysis shows that retail park rent collections were at 53% and 52% in June and March respectively, while shopping centres went from 45% in March to 39% in June. This puts significant pressure on landlord’s own income streams, while forcing the issue on whether current rental levels and leasing formats are sustainable.

As a consequence, 86% of landlords expect shopping centre rents to fall, with rents anticipated to fall by 22% on high street, 30% in shopping centres, 13% on retail parks and 34% on leisure schemes, by the end of 2021, following the Covid-19 pandemic (see chart below). RICS forecasts rents for retail properties to fall 10–14% this year alone.

On average retailers are typically seeking an average of 30% reduction in rent across their estates, or are seeking alternative lease models, such as turnover rents. At the end of 2019 turnover deals accounted for <10% of UK leases, but have come under the spotlight recently due to Covid-19 forcing a rapid reflection by the whole retail industry of the future role that affordability should play in what tenants commit to paying their landlords.

Will turnover rent negotiations change the retail sector for good?

Turnover rents have been discussed in the industry for years, with 90% of retailers already having existing turnover leases within their portfolios. With challenges in the retail sector over the last decade, more retailers have been keen to seek more affordable rent agreements. Landlords have traditionally been reluctant to commit to turnover leases in the long term as they rely on the security of income and valuations that are still based on upward only rent reviews.

However, landlords are proving to be much more open to restructuring their leases and a significant proportion of the discussions Savills are involved in include negotiations around turnover based rents. However, recent negotiations are not necessarily intended by landlords to be a permanent fixture, but more of a way of navigating the current challenges in the sector; 74% of landlords anticipate current arrangements to only be in place for up to 24 months.

Turnover rents are by no means a straightforward alternative to traditional upward only market-based rent reviews, with few deals being identical and the terms agreed retailer, product category or location-specific. Analysis of Savills rent negotiations shows that turnover rents requested by retailers range from 1–15%, with an average of 7%. However, the detail is far more complex. Almost all deals are in some way unique, either from the turnover percentage, or baseline with ratchet top-up, or inclusion of service charges. Turnover rents may be separate from service charges, or be higher and include provision. The advantage of the latter is that the retailer has a clear view on affordability. In many parts of Europe, rents are based on Effort Ratios, where total property costs as a proportion of turnover are designed to create sustainable rental affordability.

Balancing affordability with transparency

It could be argued that a margin-based rent makes even more sense than turnovers. Margins vary significantly across the sector and could therefore be a fairer approach for each type of retailer, regardless of the products they sell. Two retailers with the same turnover could have very different levels of profitability depending on what they sell and their price point. The problem is transparency. Increasingly retailers are prepared to share their turnover with landlords, but not their full P&L. And yet if they did landlords could make more informed decisions about their assets and invest accordingly to help secure the long term futures of the schemes, to the benefit of both parties.

Another added complication of turnover-based rents is how a sale is attributed to a store. Some brands have a significant proportion of online sales, but use the stores for showrooming, click & collect, or returns. While a lot of work has been done on the ‘true value of the store’ in a multichannel world, no-one has yet worked out the true value that a specific store in a specific location has in an ecommerce transaction. For F&B/leisure measuring the performance of a specific property is more straightforward and we already see quite a few tenants within this space on turnover-based arrangements.

Challenges with valuation

A secure income is likely to remain the landlord’s preference and therefore fixed-rate leases over a longer-term will likely still be the first choice. Of course in the current environment, this doesn’t mean landlords will get what they want. Leases are shortening (see chart below) and several landlords are looking to opt for a hybrid model with a base rent plus a turnover top-up. This can be preferable for a retailer compared with a fixed-rate lease and still provides the landlord with some level of income security.

Perhaps the biggest challenge for the property sector of turnover based leases is with asset valuation. Firstly, valuation based on turnover leases typically reviews the previous three years sales evidence and asset values become closely aligned to the volatility of market economics and consumer confidence, rather than based on landlord guaranteed income over the long term. Secondly, in many markets where there is little history of turnover leases, there is no comparable evidence. Thirdly, property value becomes heavily weighted to the turnover of a specific store rather than the benefit that store has in the retailer’s supply chain. While Valuers in Europe have contended with these problems for some time, it is evident that it remains incredibly challenging and is far from a perfect solution.

How are lease lengths reducing?

Lease lengths have reduced significantly in recent years. Savills analysis has recorded a threefold increase in leases shorter than two years between 2018 and 2020. In 2016, leases of 6–10 years accounted for around 55% of deals, but by 2022, 90% of new leases are anticipated to be shorter than five years.

Lease terms requested by retailers average 5.5 years, with several retailers keen to fix terms for 10 years. However, it is currently more common for landlords to agree and switch to turnover terms for shorter periods (two years) to help navigate the current market challenges, but not commit for the long term. However, this cannot happen within the L&T54 Act as that would make any new agreement a permanent fixture. Therefore several landlords are looking to agree short-term deals outside of the Act; which many in the industry already see as applying outdated constraints to leases.

It is worth highlighting that the vast majority of leases will remain untouched by the end of the crisis and current projections suggest that at the end of 2020 turnover leases will still account for fewer than 10% of leases.

Without a lease expiry event on the horizon there is little impetus for landlords to consider re-gears or alternative leases, so much of the noise we are seeing at present is a trickle of deals being agreed. The majority of leases that have no events coming up are likely to remain on traditional rents for the time being. However, L&G and Hammerson have both voiced their intention to introduce a more flexible approach to lease structures over the coming years.

_{Read the articles within Spotlight: UK Retail Outlook Report  below.}