In the past 18 months, there has been a significant change in the UK retail market. COVID-19 lockdowns and other restrictions have meant more shopping now takes place online, leading to fewer in-store sales.
Many retail units have thus become unviable at existing rental levels. In turn, a plethora of high-street brands have failed, and the leases of other struggling tenants have needed restructuring to ensure affordable rents.
This has seen some stores switch to turnover leases, where a percentage of rent is related to their income. Sometimes this switch has been negotiated with landlords, and in other cases imposed as part of company voluntary arrangements (CVAs).
A shift in the way the retail market worked was apparent. So in May, the Investment Property Forum (IPF) commissioned research to understand this shift, and its implication for future valuation and investment a copy of the full report can be found on the IPF website.
The IPF carried out an indicative survey of owners, agents and valuers. The researchers initially sent a questionnaire to each group to obtain confidential findings. These were aggregated and then shared with respondents for discussion in follow-up interviews.
One of the principal questions was to determine how prevalent turnover-based leases had become. Did their use represent a structural change in the market, or a temporary variation to help ease the economic strain of the pandemic?
Although the survey covered all property sectors, the results showed turnover-based leases predominately being used in shopping centres, by fashion and by food and beverage companies in particular. Around 15% of all shopping centre leases are now turnover-based.
The research found several reasons for using such leases. In many cases, they were designed to share potential benefits between landlord and tenant, because they enabled proactive asset management that would increase turnovers.
Equally, some leases had been agreed where turnovers were likely to keep falling, and thus the landlord would receive no additional rent. In these instances, they were just a mechanism to help to rebase the fixed rent at an affordable level. In other cases, turnover leases were simply a way of getting a tenant to cover at least service charges and property tax liabilities.
One argument advanced by respondents for turnover-based leases is to link the affordability or worth of the space to the rent being paid. However, fixed rents can also be set at an appropriate level, as long as the landlord recognises that the rate a specific space can command will vary according to the type of occupier.
In both cases, the best rent a unit can readily achieve – market rent – will no longer be determined only by the unit's location in the centre but also by the likely tenant. This represents a significant change in the market. But the increased use of turnover-based rents is just one part of this more complex picture.
Although some turnover-based leases may revert to fixed rents as we emerge from the pandemic, indications are that shopping centres will use a range of agreements in future. The split between fixed or turnover-based leases will depend on both the owner's management strategy, and how far occupiers accept turnover leases.
Turnover rents will work best where landlord and tenants are willing to work together to promote the centre. This means a move towards the outlet business model, and a change in the way that predominately turnover-based centres are valued. It will also need tenant and landlord to share turnover data, with the landlord collecting individual data from all tenants and then aggregating the information and returning it to the occupiers so they can assess their relative performance within the centre. This may not capture the impact of offsite sales and brand reach, the so-called 'halo effect', but the experience of outlet centres, which operate in this way, shows that the new collaborative relationship between landlord and tenant helps address such issues in a more constructive partnership.
In accordance with internationally agreed definitions, the RICS Red Book confirms that all valuation methods attempt to determine market value. The technique chosen to do so is known as the valuation model, and it can be done implicitly or explicitly.
The implicit model identifies the attractiveness of the investment, including all risks, by capitalising the current net rent to determine the market value. Conversely, an explicit model projects the expected future rent and property expenses as a cash flow and then discounts this at an appropriate rate. This is also known as the discounted cash flow (DCF) model.
The IPF research notes in the UK, the implicit model is preferred for valuing shopping centres, although the DCF model is often used as a check. Where a shopping centre chooses to become a predominantly turnover-based asset, it is likely that the DCF model will start to be used as the principal means of valuation. In this case, sharing data on individual turnovers and aggregated norms will have to become standard practice.
The IPF research suggests the implications for valuers may be as follows.
These will continue to be valued by an implicit model unless turnover rents begin to predominate, in which case the full valuation will use an explicit model. However, market rents will be determined not by a tone for the whole centre, but based on the likely occupier type. This in turn will be based on effort ratio (rent as a percentage of sales).
Such leases will require the landlord to share turnover information with the valuer. The valuation will move away from comparisons to concentrate on the actual income, with reversion determined by the type of occupier. It will also be likely to use an explicit model.
Although the owner will confirm that rent is being received on this basis, the valuer will need to determine whether the turnover element is likely to continue in future years as this will affect the way in which the reversion is to be valued. But as it is easier to model in the implicit valuation, this element is often considered too remote to include in the valuation and only the base rent will be considered.
Where fixed rents are still being used – as is likely in most centres for the foreseeable future – the implicit model will prevail. Even so, the determination of market rent will still become more complex as it aligns more closely with the affordability of the space by different occupiers.
Although turnover leases may become the norm for some shopping centres, others will revert to predominantly fixed rents. The change will affect the profession in assessing market rent and choosing the appropriate capitalisation valuation model to determine the market value of the asset.