As businesses quantify the economic losses caused by the lockdown, many will be scaling back their expansion plans or even consider downscaling. Such activity will impact the property market by forcing landlords to accept more tenant-friendly terms. As a result of this shift in the balance of power in favour of tenants, we will see more flexible leases in the future.
The lockdown has undoubtedly had a significant impact on businesses, particularly the retail and leisure sectors. Most retail and leisure businesses occupy premises under a traditional lease model. This type of lease is typically for a long duration, paying fixed market rent, and with limited or no options to terminate. The traditional leasing structure does not always fit an evolving market where businesses have to adapt to changes quickly.
Landlords are starting to recognise the need for change in the wake of the pandemic. For example, Legal & General’s LGIM Real Assets has launched a new flexible leasing framework to better engage with retail and leisure tenants. We are also seeing an increasing number of landlords accepting/offering a change to ‘turnover-based rents’. For a lease to be considered flexible, the terms must be adapted to suit the occupier. Below are examples of how adjusting a term can increase the flexibility of a lease:
Lease Duration - A traditional lease has a duration of ten years or more. While a well-established business with solid financial performance will favour such a conventional lease model, a start-up business will prefer a shorter lease duration. The advantage of a shorter lease is that the tenant is not committing to the same space for an extended period, allowing for flexibility in planning for growth and operational changes. Not all start-up businesses will be successful, and those that are successful will have to adapt to changes.
Turnover Rents - A rent based on the financial performance of the tenant’s business allows the landlord and tenant to share the risk as well as the reward. There is no rule as to how turnover rents should operate, and the landlord and tenant are free to negotiate this. A widely accepted form of turnover rent is a combination of a fixed base rent plus a percentage of the turnover. For example, suppose the market rent is £200,000 per annum. In that case, an acceptable turnover rent could be the sum of £120,000 plus 10% of the turnover. There are other important factors to consider, such as defining and verifying turnover, conditions to be met by the tenant, confidentiality, and how to resolve a dispute.
Break Option - In a traditional lease, an option to terminate is usually for fixed intervals, for example, every fifth anniversary in a twenty-year lease. That does not give the tenant much flexibility to deal with an uncertain future. A flexible break option can be on a rolling basis subject to a long notice period. For example, for a five-year lease, the tenant can terminate at any time after the first two years with a nine months’ notice requirement. Generally, the shorter the lease duration, the less need there is for a break option.
Permitted Use - A broader user clause can facilitate changes to consumer habit and expectation. For example, we have seen one high-end fashion brand opening a café section in its flagship store to enhance the customer experience. And some restaurants have started operating separate bars or cafés to diversify their business. At the same time, landlords need to have some control over the use of the property. One way of achieving flexibility without diminishing the landlord's control is to give the tenant an option to change the permitted use with the landlord's consent.
A flexible leasing structure is like a partnership between the landlord and the tenant. Negotiating and agreeing on the flexible terms is only the first step. Incorporating the flexible terms into a lease, in a way as intended by the parties, is equally as important.
If you would like advice on negotiating or entering into a flexible lease, please do not hesitate to contact us.