How Covid has turned retail rents on their head

In many ways, retailers have never had it so bad. But when it comes to their relationships with landlords, and especially if they’re in grocery, or have otherwise been able to stay open – they’ve never had it so good.

Even before the pandemic, the inexorable rise of online meant retail property values were falling, giving occupiers an upper hand in negotiations.

Now Covid has truly turned the tables. When the government banned landlords from evicting tenants and blocked legal routes to debt recovery last spring, occupiers were effectively given free rein.

Add to that the woes of retail itself, with non-essential shops closed, businesses collapsing and vacancies rising, and you have an “occupier’s market”, says British Property Federation director of finance policy Ion Fletcher. It means landlords are “likely to do whatever they can to hang on to the occupiers they do have”.

So what changes have retailers pushed for with this newfound position? And what will they mean for the market in future?

By largely removing the threat of rent debt enforcement, the government’s emergency protections created an obvious opportunity for retailers to move from paying rent quarterly in advance, seen as an anachronistic burden by many, to monthly. The latter is “far more normal” than the traditional quarterly, says Tim Davis, partner at commercial real estate company Cushman & Wakefield.

Some retailers, such as Poundland, have gone further. The discount retailer made the unusual move to payments monthly in arrears instead of advance. “Traditionally rent is paid quarterly in advance.”

Poundland could make these demands by fortune of having the majority of its stores open during national lockdowns. Set against a backdrop in which many retailers are closed and paying no rent at all, landlords accepted Poundland’s terms. Last June, the variety discounter said it had moved to the arrangement across all stores and was negotiating the payment schedule into the terms of new leases.

It serves to illustrate the power held by stores that are continuing to trade. Even some supermarkets, insulated from the changing landscape of the wider retail property market by booming sales during the pandemic, have considered moving to monthly payments.

“We had a conversation probably in May of last year with all the landlords to whom we still pay rent quarterly in advance, to ask whether we could convert to monthly in advance,” says Iceland property and acquisitions director Simon Anderson. “There was a mixed response. Some people were more than happy, from others it was a flat no.”

Iceland chose to squeeze no harder because, with shops open and trading well, “we didn’t believe it would be appropriate or right”, Anderson adds.

H&M’s deals

Landlords may be struggling to achieve a consistent approach across portfolios, but retailers are not necessarily suffering the same problem.

Property experts point to H&M as an example of a retailer that has used a consistent approach to gain more favourable terms across its estate.

The business had been tied to traditional, fixed-rent leases struck several years ago, when values were higher, says a landlord source.

“They probably burnt their fingers in the UK market going back eight, nine years, when they were agreeing big rents,” says the source.

The fast fashion retailer now pushes uncompromisingly for total occupational cost deals.

“It could be paying a percentage of turnover anywhere from 7%-18% but it will be an all-inclusive rent.

“They’ve found some traction because they’ve been very black and white about it. That can be frustrating, but the head office is very much of the position that ‘this is our global model, this is how we’re going to do it and if you don’t agree we won’t take space’.”

An H&M spokeswoman said it was in “frequent dialogues with our partners to ensure these agreements are mutually beneficial”.

But frequency of rent payments isn’t the only thing changing in the wake of Covid-19. Even calculating a reasonable rent has become a point of controversy. With non-essential retail closed in lockdown, property transactions themselves all but ground to a halt, making it “very difficult to know where rents are”, says Davis. “It’s close to impossible to value a property from a rental perspective. You can still make judgements but the range of where it should be is wide.”

So rent is increasingly being based on a retailer’s turnover. That method has been gaining popularity since the global financial crisis of 2008, says Davis, but its proliferation has accelerated during the pandemic as it becomes ever harder to value properties.

Knight Frank partner David Legat says: “In some ways, Covid has ignited a revolution because the majority of deals we talk about are now turnover-based.”

Indeed, the 1954 Landlord & Tenant Act, setting the framework of traditional leases with fixed payments based on a value attached to a location, had long been of dwindling relevance – but Covid has pushed it to the point of obsolescence. In December, the government announced a review of the “outdated” legislation, set to launch this year and due to consider alternative leasing models.

“It’s close to impossible to value a property from a rental perspective”

The Act is obsolete because occupiers have “no regard for what anybody next door is paying,” says Legat. “If you say a property is Zone A to a retailer, they will laugh down the phone at you. It’s just not the way it works anymore. Instead, people come to you, saying ‘We turn over X, so we can pay Y’.”

There are different ways of calculating turnover-based rent. Occupiers can either make base rent payments that are topped up with a percentage of turnover, or commit to a ‘pure turnover’ lease that is determined entirely by trading levels. The job of property agents has “quickly evolved” to include determining what the percentage should be based on volumes and margins expected from the type of retailer, says Legat.

“Depending on what their margins are, different occupiers pay a bigger turnover percentage. So, coffee shops will pay a higher turnover percentage than fast fashion.”

An in-house Knight Frank research team helps inform an “educated guess” at the turnover and margin levels. “For us this has become quite standard, especially over the past six to 12 months,” Legat adds.

In a shopping centre, the base might be 80% of the usual market rent, while the top-up could be anywhere between 5% and 10%. “Most retailers talk about percentages of between 5% and 8%,” says Davis. “Landlords want as high as 10%, but are generally fortunate to get 7%-8%.”

Since lower turnover will mean lower rent payments, it provides a level of protection against further government-enforced closures or declining footfall in lockdowns. Retailers to have embraced the arrangement include The Fragrance Shop, which has agreed pure turnover leases on roughly half its 200 stores.

Major landlords aren’t averse to these turnover deals, either. “There’s a myth in the market that landlords are anti-them, but if they’re structured correctly there’s not a problem there,” says a source.

“Occupiers have no regard for what anybody next door is paying”

“In fact, we tend to try to embrace them. If you believe in the quality of your assets, you can be comfortable taking a turnover rent because you know the footfall is coming back.”

Where such deals become less palatable to landlords is at the mention of upper limits on the top-up, or “turnover caps”, the source explains. “We have a lot of conversations about that at the moment, where they’re saying, ‘You share the downside if we don’t do the turnover but we’re not going to give you the upside’.

“That’s where it starts to get inequitable. The likes of River Island and JD Sports want to bring in some sort of cap on turnover.”

The worst culprits, in this respect, are food retailers and variety discounters, who have such an aversion to sharing the ‘upside’ that they won’t even entertain turnover deals.

As Poundland head of portfolio management Ben Wall told The Grocer last year, they would prefer the landlord simply recognise the property is not worth what it was. Turnover leases “avoid the need for the valuation of the property and unfortunately the valuation is the inconvenient truth for a lot of landlords”, Wall said. “In the majority of areas, values have fallen. Agreeing turnover rent to protect the value is not the right thing to do.”

Shorter leases

Alongside a reappraisal of rental value, landlords are also having to consider other concessions, ranging from rent-free periods to shorter leases. The latter is another long-term trend that has accelerated in the wake of the pandemic.

“When I started my career in 1989, just before the big recession, leases were all 25 years,” says Davis. “They’ve got shorter and shorter, and five years with a break option at three is almost the standard.”

Iceland, for one, anticipates being able to secure more short leases as a result. It finds them useful because it is “very difficult to predict how some traditional high street locations we’ve traded in for many years are going to weather the storm”, says Anderson.

Exceptions include bigger supermarkets, which prefer the security of longer leases because of the high cost of opening and fitting out a store in the first place. A similar story remains true of ‘big shed’ variety discounters, says Knight Frank partner Richard Petyt.

“Home Bargains, for example, still want reasonably long leases because they invest quite a lot into shop fits,” he says. “B&M and The Range are similar.

“I haven’t come across any of them looking at turnover deals. They’re just pushing on the standard terms, with a better deal on the rent and rent-free periods. If they can, they might even buy the freehold.” 

Of course, a traditional rent deal provides no protections against falling footfall in any future lockdowns, but here landlords face another new pressure: ‘Covid clauses’. Their terms are varied. “A Covid clause could mean reduced rent in lockdown or it could mean it goes on to turnover rent for that period,” says Gareth Birch, associate partner at commercial law firm Pannone Corporate.

Although the detail is not standardised, the existence of Covid clauses is becoming so. Poundland has been inserting them into new property deals since the first lockdown. WH Smith has been demanding them in lease renewals in a belief they will become the norm. It is arguing that in events such as the Covid-19 pandemic, its rent liabilities should effectively cease.

“The past 12 months have been the most painful I think anyone can imagine”

The presence of Covid clauses is perhaps one of the few areas of growing consistency in the ‘new normal’ for landlords. Essentially, they are now having to adjust their expectations of how a deal should be structured according to the wishes of retailers and their individual circumstances.

“Every deal is on its own merits,” says Legat. “It depends on location and the occupier.”  He believes the imbalance of power in the occupier’s favour “will stay that way for a while yet” in the retail market.

A landlord source agrees: “It’s a buyer’s market. Real estate has gone through the wringer.

“The past 12 months have been the most painful I think anyone can imagine.”

Like Intu, the shopping centre-focused real estate company that collapsed into administration last summer, some will not make it out the other side of that wringer. But out of these tough situations comes hope of some kind of return to stability, argues Legat.

“I think the upshot of the pandemic will be in relation to the investment market,” he says. “It will be the acceptance of the true value of these assets. The willingness – some under duress, some just cutting their losses – to trade these assets at a fraction of what everyone was pretending they were worth.”

As portfolios change hands, new owners, having paid less for them, will be more able “to deal with this variety of deal structures to suit different occupiers, and work back to full occupancy”, Legat adds.

So it seems the full impact of the pandemic on the retail property market has yet to unfold. And the newfound power of retailers doesn’t look like it will go away anytime soon.

Alternative rent models: what the experts are proposing

Model 1: CACI

While many retailers have embraced turnover deals, “retailers can be very sensitive about sharing turnover data”, says a landlord source. In particular, “when you start talking about click & collect and so forth”.

CACI’s model looks to address such sensitivities while also giving landlords access to some of their online revenue which, they argue, is boosted by online fulfilment.

As data specialists, CACI is already provided with sales data and shopping centre footfall by a number of retailers and landlords. Under its model, the two parties do not see each other’s numbers, only any resulting change in the top-up calculated from them by CACI.

Can it catch on? Not for everyone. Independent landlords don’t necessarily have site footfall data to share. And “there will be certain brands who say we don’t want to do that”, admits CACI property consulting group director Alex McCulloch. “It’s not one size fits all. That’s how we got into this problem, with one-size-fits-all solutions.”

Our landlord source says: “It’s a tough one. If you are one of the few retail customers acquiring space, you’re not looking to pay a fair rent, you’re looking to pay the lowest rent possible. So, do you want to be signing up to a CACI index designed to make you pay a fair rent?”

And, adds Knight Frank’s Richard Petyt, of food retailers, most “will not be in the slightest bit interested in sharing trading information with anyone”.

Model 2: Colliers

Property advisor Colliers is also working on a new model designed to tap online profit, but without the need to analyse individual retailers’ online sales.

“We completed our own analysis of over a quarter of a million online transactions for a brand and found over 50% took place from a home location within five miles of one of the stores,” says Colliers head of retail strategy Matthew Thompson.

“Therefore the benefit of having a store to online sales is unquestionably there,” he explains.

Colliers’ model proposes a base rent with a top-up that rises in proportion to the number of people passing and entering the store, based on the argument that exposure has a value to the retailer online.

The model depends on sharing of “turnover information at store level” but not online sales in the shop’s catchment area.

Like CACI’s, the model will not suit everyone. It lends itself to “owners of major shopping centre schemes” and retailers with “a good blend between physical and online turnover”, like fashion and health & beauty operators.

Model 3: TOC

Not a new model, but another that has been increasingly adopted in the pandemic, total occupational cost (TOC) leases are turnover deals that simplify property outgoings for retailers.

“Rather than pay 6% or 7% turnover, retailers might agree to pay 13%-15%, but it covers all occupational costs: rent, rates, service charges and insurance,” explains Knight Frank’s Legat.

It “de-risks” the cost for the retailer, although it may mean sharing more of any unexpected trading uplift.

However, while such deals are “gathering pace”, increasing uncertainty in the past six months over the long-term future of business rates has detracted from their appeal.