Could Turnovers Turn Out Traditional Valuation Techniques?

The changing retail leasing model

In the blog Turnover Turned Up, published on 8th May 2020, the REPAIR Team reported the growing use of turnover rent terms prior to the pandemic. More recent interviews highlight that the pandemic has only served to accelerate the shift towards turnover-linked rents as more landlords, historically resistant to such deals in the UK, have had little option but to accept the turnover model. In the intervening period turnover-linked rents have replaced fixed rents under Company Voluntary Arrangements (CVAs) in 402 New Look stores and many of Caffe Nero’s 650 stores, reflecting the significance of the shift to turnover-linked rent occurring in the wider retail market.

The concept appears, on the surface, reasonable enough in that landlords will share in the successes of their tenant but will support them in times when they are struggling. In practice, however, the delivery of the promised benefits is less clear-cut with the move driven by tenants de-risking their physical store holdings rather than by the landlords. Landlords’ dislike of the turnover rent model is associated with the complexity of turnover deals, the lack of transparency around retailers’ turnover in terms of the data supplied to calculate their rental income and the non-existence of benchmark metrics to help landlords gauge the performance of such deals.

Need for improved transparency

The mechanics of turnover rents are, in most instances, relatively new to landlords, tenants, agents and valuers in the UK retail property market. There also appears to be no standard approach to the different elements determined within the turnover lease. Turnover deals might be a base rent (typically 60-80% and occasionally up to 90% of market rent) with a turnover top-up, or 100% turnover, but it is not obvious to inexperienced landlords how turnover percentages are set to reflect the dynamics of the retailer’s operation, their performance projections and the relationship between turnover and margin for different types of retailers.

This ambiguity around turnover deals exists even before the lawyers thrash out the more contentious terms underpinning the measurement of turnover, the different ways, if at all, online sales are included as part of the turnover, or the approach taken to account for the refunding of items bought online and returned to a physical store. Currently there is not even an established industry-wide approach to allow for physical stores that support internet sales, for instance, showrooming and click and collect.

Some property managers have access to an occupier’s sales data via an Electronic Point of Sale (EPOS) system but proof of turnover for many landlords does not even rely on professionally audited figures, although they often have the option to request independently certified accounts if they are concerned about the reliability of the figures claimed by operators. Hence, transparency and trust, two essential attributes in the building of a solid working landlord and tenant relationship, are sticky issues in the turnover partnership. The role of the landlord in this relationship is typically outsourced to professional advisers by the many absent overseas or private owners who do not have the skills or experience to support tenants in this complex and increasingly fragmented investment market.

Implication for valuation practice

Perhaps more interestingly, turnover-linked rents, in combination with shorter lease terms, more frequent tenant-led breaks, non-payment of rents, and uncertainty around business projections that make retail more of a volatile cash-equivalent investment, may mark the beginning of the end for the traditional income method of valuation. Historical modifications handled turnover income by capitalising in perpetuity at a higher rate than the yield used on the more stable base rent, but term “certains” are now much shorter, possibly even a thing of the past, and the assumption that assets are re-let at expiry is no longer defensible given the other changes experienced in the leasing market.

So, valuers have to rise to the challenge and devise an alternative methodology to better handle the complexities emerging. One option may be to adapt the full income capitalization approach, used to value hotels and other going-concerns. This offers a sensible way to explicitly allow for different revenue streams, income voids and associated operational costs in shopping malls, and could be scaled back to deal with standalone units.

Another option is the development of a Discounted Cash Flow (DCF) model which is flexible enough to handle non-recoverable costs, incentive packages and more realistic income projections. DCF valuations can adapt to most rental situations, not just those under turnover agreements, and can be used in combination with detailed income and value analysis and investment value appraisals. These are widely used outside the UK to valuation turnover details, and academics and practitioners alike have argued such a change in practice would avoid over-pricing. Yet, a switch to contemporary methods will not be easy in an industry that has resisted this move for decades.

Either valuation approach would see a fundamental change in the way the retail asset class is priced with commercial valuers not only changing their valuation method but the nature of the data they are required to collect and analyse, perhaps even leading to this branch of valuation becoming highly specialised in the same way going-concern valuations tend to be. It also depends on greater transparency and data sharing in the market to provide landlords and valuers access to appropriate data, although a surprising change during the pandemic was that most retailers were willing to share details of their turnover, which possibly lays the foundation for the necessary cultural shift.

Implication for Business Rates

As a final point, it is also important to acknowledge the implication of the change in the leasing model for the valuation of business rates. Assessors currently rely on Zone A market rents. If these inputs no longer exist because the retail market now deals in turnover rents or rent per square feet as total occupancy costs, then this will impact on the way the VOA/SAA gathers, analyses, and applies market evidence. Subsequently, the establishment of the turnover model as the dominant practice in the retail market could (at least in theory) trigger a move towards turnover-linked rateable values, which has potential to level-up the taxing of bricks and mortar and online retailers.

The next scheduled tone date is less than six months away so perhaps hopes for a radical change for the 2023 revaluation are fanciful. Assessors would need time to undertake the pre-requisite investigation into defining turnover, suitable rental percentages and data collection methods, which ultimately brings me back to my original point that transparency needs to improve to ensure suitable turnover data is available to the market. Here technical innovation and closer collaboration between landlords, tenants and assessors would be necessary to make this workable.

Way forward

If I was a betting person I would put my money on the switch to a hotel-style traditional valuation approach being more likely than a DCF method as there is precedent using this type of approach and it represents the path of least resistance. However, instead of trying to second guess the way the market is moving, a better alternative might be for the RICS Valuation Professional Group to undertake a systematic exploration and evaluation of global best practice to find out how retail assets are valued in other countries with similar lease models. This review should set the way for acceptable revisions to the retail valuation model as well as build landlord and lender confidence in turnover deals.

Allison Orr

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