Rents, Returns and Turnover in the Age of Online Retail

News has surfaced recently that H&M has approached some of its landlords with a view to agreeing bespoke turnover rent arrangements for new leases and for lease renewals. The arrangements take the form of "total occupational deals" as they propose offering landlords a single sum as a proportion of turnover for each store to cover service charge, rent and business rates.

H&M's proposals have been described as particularly "aggressive" (The Times) as it has also demanded that the cost of returns that come into a particular store, whether from in-store purchases or from online sales, be deducted from its turnover figures. 

Alongside rent free periods, break clauses, service charge caps and other concessions, turnover rents have become an increasingly common feature in retail lease negotiations as tenants demand more tenant-friendly deals in light of difficult current trading conditions and the surplus of retail space on the market. These indicate a 'shift in power' in favour of tenants and landlords are aware that, even once lease terms are agreed, they may face further difficulties with tenants, as evidenced by the announcement this month that John Lewis intends to withhold 20% of this quarter's service charge for certain locations.

However, seeking to have the cost of returns deducted from a store's turnover figure should not necessarily be viewed as an "aggressive" move. It is arguably the next logical step for retailers in an increasingly online sales based environment where there is no opportunity to "try before you buy".

Retailers are facing rapidly increasing levels of returned products, posing new challenges in what is already a difficult trading climate. Forbes have reported that between 25 – 50% of online sales by retailers are now being returned either in-store or to distribution centres around the country. The increase has been fuelled by retailers responding to consumer demand for a quick, easy and free returns process, which is necessary to support the online sales boom. 

While generous returns policies may have brought a welcome boost to the volume of sales made by retailers, there is a significant downside as retailers receive no income from returned sales and they must spend significant sums cleaning, re-packaging, and re-distributing returned products. Indeed, The Times recently reported that it costs on average £12 to process a returned item and returns cost retailers at least £60 billion a year. Therefore, while such policies have been necessary, retailers such as H&M will be arguing that its landlords should accept their share of the cost. 

A common objection raised by landlords to standard turnover rent arrangements is the risk they would take on by binding the financial success of a real estate asset to the performance of a business which they have no control over. Factoring returns costs – especially returns generated by online sales - into turnover rent arrangements brings a further unwelcome layer of uncertainty. Landlords are typically not retail experts and historically they have relied on a steady income stream from inflexible, long term leases with fixed or upward only rent provisions. 

However, with current retail vacancy rates, which this summer reached a four year high at 10.3%, and footfall falling to its lowest level in seven years (British Retail Consortium and Springboard survey), there is significant pressure on landlords to be flexible and respond to changing market conditions. In other words, landlords are increasingly being forced to share certain levels of business risks in order to attract tenants. 

Alongside other forms of collaboration increasingly present in retail landlord and tenant relationships, such as data sharing and 'place-making' initiatives, turnover rent arrangements are often seen as a way for landlords and tenants to work together to ensure their mutual success. H&M's proposals should be seen in the same light and, in the current climate, they are a step forward in the right direction to ensure bricks and mortar retail remains viable in the future. 

Nevertheless, arrangements that deduct returns need to be carefully structured to ensure that they work for both parties and, as with any new innovation, many questions remain that need to be addressed (such as how to allocate online returns to different stores) before the idea is widely accepted.  While it is therefore unsurprising to read that some landlords have raised objections, the industry as a whole will benefit if landlords are open to change and willing to engage in the necessary discussions.