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Pros and Cons of Percentage Rent

European retail landlords are embracing the percentage rent model, in which a tenant pays a base rent, plus a portion of its sales, or turnover, rather than a fixed sum. Will the practice gain traction in the U.S.?

Photo Courtesy of Shutterstock / julia.m.

“UK landlord Legal & General just offered turnover-only leases to all tenants, which would be unheard of a year ago. Fixed leases are almost nonexistent,” international omnichannel strategy consultant Gary Burrows said on a recent ICSC Connect Virtual Series called Omnichannel & Digital Transformation, Part II: Operations.

“In the UK, we moved a long time ago toward base rent plus turnover,” said Burrows, managing director of Malls and Meeting places for FitForCommerce. “In some cases, it’s turnover only, which … de-risks the situation for retailers, but it amasses the risk onto the landlord.”

The percentage rent system is less popular in the U.S., where many landlords doubt whether tenants will report sales accurately, said Mark Burlton, managing director of retail consultancy Cross Border Retail. “If we are going to move away from fixed-term leases to percentage rents, then there has to be a better element of trust.” Every tenant is capable and required to know the exact turnover of their individual stores, and they should have to share that information with landlords, he said.

The effort would be worth the end result, Burlton added. “If we go to a percentage rent system, the potential for upside is there. If we don’t do that, there is no real potential for upside in the current climate and we are in danger of destroying the very fabric of our towns and cities.” Percentage rent leases must ensure landlord remuneration for omnichannel transactions that pass through the store, Burrows said. “A lot of those stores, especially grocery stores, are fulfilling from stores, so why is the landlord not receiving a portion of that income?”

Brokers won’t be happy because they’ll earn less money upfront on new leases. Methods of calculating commission might need to evolve to address that, Burrows said. “There’s no prescribed way of doing this. It may be done on a projected turnover base because fixed rent in the first year is going to be low, or they could take a percentage over a few years.”

“Only by working with tenants to improve turnovers will they then elevate the value of their assets back to where they were before the pandemic”

Naysayers also claim percentage rents make net operating income projections for investors more difficult. “Some landlords are saying we literally cannot do percentage rent because our financers wont value it, but the factory outlet industry has operated on base and turnover rents since Day One,” Burrows said. “The investment team applied a different multiplier to reflect the fact that the income is less certain.”

Some landlords are afraid to admit their properties have lost value, he added. “Multipliers are smaller so value of assets are lower, and only by working with tenants to improve turnovers will they then elevate the value of their assets back to where they were before the pandemic.”

The UK has helped align landlord and tenant interests, Burlton said, having introduced a moratorium on aggressive landlord tactics. “It’s forcing landlords and tenants to discuss new ways of relating to each other. Rents will inevitably come down. They’re already coming down. We have to work with the landlords to help them survive. We need landlords to survive in the same way that we need our tenants to survive.”

UK insolvency law also includes a company voluntary arrangement that allows financially distressed retailers to close stores that aren’t making money and to reestablish their businesses just with profitable stores, Burlton said. “Landlords kick and scream, but they nearly always end up approving this new, slimmed-down business.

Landlords do have a right to refuse, but they are choosing to allow retailers to bust out of their lossmaking stores as long as the lion’s share of their stores survive and pay rent at that new level.”

Source: 2020 ICSC.

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