Property briefing: with the retail sector in a parlous state, the traditional landlord-tenant relationship is equally under strain and new forms of lease are being tested

The coronavirus pandemic has exposed the fragility of the landlord and tenant relationship in the high street, if the recent collapses of a number of well known and indeed high profile retailers are anything to go by.

The focus by the UK and Scottish Governments in providing support to businesses, in the high street at least, has been centred on supporting employees of retail businesses (primarily tenants) impacted by the pandemic. In order to avoid similar collapses within the landlord community, landlords are now looking for support from the UK and Scottish Governments.

One option being considered is a type of furlough scheme for unpaid rent. This would allow landlords to continue to support their tenants as each sector gradually eases from lockdown and operates at much lower levels of activity, due to social distancing measures, lower footfall and with a higher cost base due to additional security and enhanced cleaning costs.

High street retailing is in a state of flux and has been so for some years now. The current pandemic has only brought that state of flux to the fore, but perhaps it will be the catalyst to a systemic change in the nature of the landlord and tenant relationship itself.

Leases of tomorrow

One particular aspect of that systemic change may be the lease structure. The consumer’s journey today is totally different to the consumer’s journey of yesteryear, yet the lease structure of today has fundamentally remained the same. Whilst alternative leasing models offer a potential solution by more properly aligning the interests of the landlords and the tenants, it is recognised that there is no one size fits all.

The International Council of Shopping Centers (ICSC) produced a research report in June 2016, Exploring New Leasing Models in an Omni-Channel World, which looked at the different leasing models in the US, the UK and across Europe. The ICSC report considered the contents of the alternative leasing model toolbox and found:

  • Fixed rent lease: Rentals are fixed to the retail price index or similar rather than open market value with, in the case of shopping centres at least, a performance based top-up designed to reward the shopping centre owner for innovation of the environment which they control and which directly benefits the tenants’ businesses.
  • Turnover rent lease: This type of lease offers a degree of flexibility around the level of base rent and the turnover percentage to allow, on the face of it at least, a sharing of the risk. However, in the world of online retailing a percentage based solely on a point of sale turnover does not recognise the contribution that the physical store makes to an online sale. Retailers often refuse to share online sales data and therefore any attempt to make allowances for such contribution through adjustment of base rent or turnover percentage is no more than an approximation.
  • Factory outlet lease: The turnover rent lease has essentially evolved into the factory outlet type of lease, which is fundamentally a turnover rent lease but often with lower base rents and higher turnover percentages. Such leases have a greater degree of flexibility around termination where turnover falls below an agreed threshold, a greater degree of control over tenant-mix and brands, and the ability to address underperformance through rightsizing/relocation or exiting by agreement, or indeed supporting the retailers through on-site events such as fashion shows. As such this model is seen as being more aligned to the interests of both landlords and tenants. However it fails, as with the turnover rent lease model, to recognise the contribution made by the physical store to online sales.
  • Geo-fence lease: Another evolution of the turnover rent lease/factory outlet lease where, in an attempt to address the contribution made by the physical store to online sales, online sales from a designated postcode catchment area are allocated to the physical store. Different percentage rates would be applied to different categories of sale so that click and collect, in-store ordering, etc are accounted for in assessing the physical store’s contribution to the online sales.
  • Alternative performance metrics model: This model was suggested by both landlords and tenants, and recognises not only the contribution made by the physical store to sales but also the investment and management experience of both retailers and their landlords in delivering the sales and rewards for both their efforts. In order totake steps towards that outcome, both landlords and tenants will require to collaborate with each other and agree new performance metrics to determine appropriate and workable rent metrics. That will be founded in understanding and leveraging the big data captured by both landlords and tenants.

Blurring the line

Lines between bricks and mortar retailing and online retailing are being erased as retailers integrate their online and offline businesses. The role of the physical store, rather than being marginalised, is seen as being key in the marketing and fulfilment of an online order. It is hoped that this shift to omni-channel retailing will, with the availability of big data and analytics in retailing, underpin the alternative leasing models of the future that will be required to meet the future challenges of high street retailing.

The touchpoints from the consumer’s interest in an item to a completed sale are many, varied and complex, and the ability to track that journey through the capture of data is paramount to the landlords and the tenants agreeing appropriate and workable performance metrics. It must be recognised that if there is to be a step change through understanding and leveraging off of these data, there needs to be collaboration, agreement and innovation around the data whilst, at the same time, addressing the issue of privacy in how the data are captured, managed and utilised.

Where does value lie?

The Achilles’ heel of alternative leasing models has been the perception (and indeed often the reality) that value is eroded. However, whilst that may be the case for some, it is not the case for all. The factory outlet centre appears to have enjoyed a measure of success over its big cousins in the shopping centres in recent years. Clearly this cannot be wholly attributed to the lease structures adopted, and there will inevitably be other forces at play, but it does demonstrate that there is life (and value) beyond the fixed rent, full repairing and insuring lease model.

Each of the available alternative leasing models, as indeed the fixed rent model, has a role to play in the landlord and tenant relationship of tomorrow. However they are not without their challenges, be it the impact on value or the inability properly to recognise the physical store’s contribution to online sales or the embryonic stage of the alternative performance metrics model. The landlords and tenants of tomorrow, if they are to navigate their way out of the current fragile market, will require to adopt the most appropriate leasing structure for their property, one which is flexible and dynamic in the way it not only aligns the tenant’s performance from the unit and the landlord’s asset management skills but which also provides low risk with a diversified but consistent income growth.

Question of survival

Both landlords and tenants have their interests to protect and may be reluctant to engage fully with each other. However, if a step change in the landlord and tenant relationship is not achieved, the retail collapses of the recent past may continue unabated and the voids that will inevitably follow may lead to the closure of the shopping centre. That, in turn, may lead to the potential collapse of landlords unable to remedy covenant breaches associated with the drop in rental income, not least as a result of the current pandemic.

Whilst the future of retailing does not rest in the hands of the landlords and tenants alone, they have a significant role to play in shaping a sustainable environment that will allow retailing to flourish in the years ahead. However, both landlords and tenants do need to come out of the other side of the current pandemic first. What is clear is that the pace of change in e-commerce, retailing and big data analytics on consumer behaviours and patterns is unprecedented, and landlords and their tenants cannot afford for their respective businesses to be left behind in the digital stone age, pandemic or no pandemic.

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.” So says Charles Darwin in his Origin of Species.

The Author

John Gallacher, consultant, Morton Fraser LLP

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