The Impact of the Covid-19 Crisis on Commercial Leases

TURNOVER BASED RENTS & PANDEMIC RELATED BREAK OPTIONS

The impact of the current Covid-19 outbreak on commercial landlords and tenants has been unprecedented. Many tenants are currently experiencing severe disruption to their businesses and potentially facing permanent closures, while landlords’ investments are at risk. As Government restrictions ease it is hoped that the commercial property sector will begin a steady recovery. It is however, certain that the impact of Covid-19 will be reflected in the negotiation and drafting of new commercial leases. Discussions around turnover based rents and rent review clauses are in addition to pandemic related break options are likely to become a regular feature of lease negotiations.

Issues faced by commercial landlords and tenants

Unlike in Britain, the Irish government has refrained from interfering with the commercial relationship between landlords and tenants. Ireland has yet to introduce any form of statutory protection for commercial tenants, many of whom are experiencing unprecedented financial difficulties and business closures as a direct result of the coronavirus pandemic.

Many tenants are currently struggling to comply with their lease obligations such as the payment of rent, insurance and service charge. As a result of Government restrictions, tenants have faced obstacles such as complying with their “keep open” obligations, if such is required under their lease. However, as it is usual for commercial leases to contain a clause that tenants must comply with legislation in force we would consider it is highly unlikely that tenants would be held liable for any such breach while the emergency measures remain in force.

Force majeure clauses are rarely found in commercial leases, and where such a clause is provided for, whether Covid-19 would amount to a force majeure event would depend on how it is defined. Such a definition is unlikely to be so widely drafted to specifically include a pandemic. Tenants who are prevented from using their premises due to Government restrictions should closely review their business interruption insurance policy and engage with their insurer. Landlords should be informed of any closures and should notify their insurers and/or lenders.

Turnover Based Rents

The recent commercial shock felt by landlords and tenants will require both to work collaboratively to protect the future of their investments and businesses. Given the demand for retail premises over the last number of years, landlords have enjoyed significant negotiating power. This may be likely to change and going forward tenants may seek to vary the terms of their leases, or negotiate new leases, to incorporate turnover rent provisions. Turnover rent provisions provide for rent to be set on the basis of a base rent in addition to a percentage of a tenant’s turnover. The base rent is guaranteed to the landlord, regardless of the performance of the tenant.

There are a number of advantages to turnover rent provisions the primary one being flexibility for both landlord and tenant. The landlord may be able to take steps to increase the performance of its estate as a whole and to keep a close eye on a tenant’s performance. This enables a landlord to intervene at an early stage should performance decline. Tenants benefit as landlords are incentivised to increase footfall and rent payable is determined by market conditions. Turnover rent provisions create a common incentive to maximise the turnover of a premises. Where a tenant is successful, the rewards are shared with their landlord. Should a tenant trade above expectations, their landlord can instantly take advantage as opposed to waiting for a rent review. For tenants, rental liabilities will be reduced when economic conditions impact turnover such as during a pandemic, thus reducing the tenant’s risk of insolvency.

However it should be noted that turnover based rents also present certain challenges. For tenants, there is high level of accountability to the landlord. While it is crucial for landlords to receive accurate turnover information, this may result in increased costs and workload in relation to data collection, reporting and analysis for tenants. Some tenants may prefer to keep turnover figures confidential. In addition for landlords auditing the gross turnover, it may be difficult to define precise parameters of the data the tenant should be required to produce. The lack of certainty regarding the amount of rent payable is seen as the main disadvantage for landlords.

In the past, turnover rental models usually operated on the basis that landlords would receive a percentage of the proceeds received from customers on the premises. Given the relatively recent rise of e-commerce, many retail stores now generate revenue using a number of channels such as click and collect services and online sales. For this reason, the exact turnover for a particular premises is becoming more difficult to determine.

The recent Covid-19 lockdown has resulted in a dramatic fall in main street shopping, followed by heightened e-commerce activity. While it remains to be seen whether this trend will continue post emergency, it is likely that landlords will seek to broadly define ‘turnover’ to ensure maximum rental yield, whereas tenants will aim to negotiate a narrow definition of the term.

As the full effect of the Covid-19 crisis on open market rents remains to be seen, many tenants will seek to protect themselves from paying a high rent for a five-year period. Rent reviews by reference to changes in a tenant’s turnover were relatively common prior to the economic crash of 2008. While rarely seen today, this method of rent review is set to become more prominent in the negotiation and drafting of commercial leases as Ireland emerges from lockdown. Landlords may seek to implement a “ratchet” rent review provision which allows the base rent to be adjusted by a percentage of the previous year’s total rent. It should be noted that such conditions may be onerous and may not be suitable for tenants with low margins.

Despite the challenges it is likely that turnover rent provisions are set to become a more prominent feature of commercial leases in Ireland moving forward.

 Break options linked to pandemics

In recent weeks, many tenants have been forced to close some or all of their premises. Unfortunately, some of these closures will be permanent. In such circumstances, tenants who are fortunate enough to have upcoming break options may wish to exercise same. It should be emphasised that break options are strictly interpreted by the courts and notices must be served in the correct form and in the manner specified under the terms of the lease on the correct person or entity.

A tenant will only be entitled to exercise a break option once certain matters have been complied with, such as vacant possession being provided, compliance with all obligations under the lease (particularly the repair covenants) and payment of rent and other specified sums due under the lease. Careful drafting is required and it is important to thoroughly review the lease to ensure compliance. As a result of the current crisis, it is expected that break options specifically linked to pandemics may become a feature of many commercial leases going forward.

Conclusion

 

To conclude, it is advisable that all parties to a lease engage early in these uncertain economic times to amicably agree terms that are acceptable to all. While turnover rent provisions may be complex in their drafting and management, in the aftermath of the Covid-19 crisis such provisions and corresponding rent review and break clauses may assist struggling businesses to remain open, and may assist landlords in securing new tenants in an uncertain market. Such provisions are likely to be drafted with events such as the recent pandemic in mind, and will provide an opportunity for tenants to strike a balance between risk and reward when negotiating with landlords.

 

Partner

mom@ofx.ie