Westfield London, which is owned by Unibail-Rodamco-Westfield, was among the U.K.'s most popular shopping destinations prior to the pandemic.
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If there were any doubts as to how listed retail landlords felt about turnover-based rents, European mall giants Unibail-Rodamco-Westfield and Klépierre made sure to dispel them during their first-half earnings calls in August.
Within hours of each other, Unibail CEO Christophe Cuvillier and Klépierre Chairman Jean-Marc Jestin made it unmistakably clear to their occupiers and the wider European retail sector that, despite the damage COVID-19 lockdowns had inflicted on many tenants, their companies would not be forced into leases based purely on turnover.
"Some tenants are very vocal about what they would like us to do," said Jestin. "But we can say what we are not going to do. We are not going to switch from the current lease structure with [minimum guaranteed rents] plus sales to only sales-based rent."
The force of their statements highlighted the threat posed by turnover rents to investor confidence in listed retail landlords. Concerns around rental income stability have dogged both companies' share price in recent years as the rapid growth of ecommerce chipped away at brick-and-mortar retailers' revenues.
These have only intensified since the pandemic hit. Unibail's stock has plunged by more than 70% since February while Klepierre's has fallen by almost 60% during the same period.
For equity analysts trying to forecast the trajectory of retail landlords' fortunes, the seemingly unstoppable trend toward turnover rents is not helpful. "The challenge going forward is, what's the ratio of fixed rent to turnover rent?" Robert Duncan, who covers U.K.-listed landlords as director of real estate research at Numis Securities, said in an interview.
Until recently, turnover rents accounted for a fairly negligible portion of a listed retail landlord's total rent, according to Duncan, meaning that analysts only had to "stick in a little bit of a bump, around 1% to 1.5% of revenue" when forecasting rental income.
If turnover rents are to make up a greater portion of a landlords' rental income, much more detailed financial data from landlords will be required, said Duncan. This should include the ratio of fixed to turnover rent received, the impact of variable rents on service charges paid by tenants, and the impact of greater variability in rental income on property valuations, he added.
"It's going to be incumbent on the landlords to start increasing the quality of their disclosure," said Duncan. "They're going to have to really step up to the plate."
How turnover rents impact property valuations lies at the heart of equity investors' concerns about the value of listed retail landlords themselves. A substantial shift by landlords toward turnover rents could provide the catalyst for significant revaluations of their properties, said Colm Lauder, real estate equity analyst at Goodbody, who has been advising a number of U.K. REITs on turnover-lease structuring in the last two years.
"The valuers' interpretation is that if there is a wholesale move or a switch to turnover leases there would be very severe markdowns in value because of the lack of definition on the income stream," he said.
Lenders to landlords are likely to look just as unfavorably on any broader adoption of turnover rents, Lauder added. "If you are servicing debt, you need a clear income profile," he said. "If your rental income has a much smaller fixed component, far more significant variable component, naturally, your debt will be more expensive, more complex or not available at all."
For listed landlords hoping to hold back the tide, moves by peers and other large institutional retail landlords toward greater adoption of turnover rents is likely to cause concern. London-listed retail landlord Hammerson PLC and the property investment arm of Legal & General Group PLC both recently announced the introduction of flexible leasing models for their retail and leisure assets in the U.K.
Such moves give a boost to retail tenants' already considerable bargaining power, said Duncan. "If you see an increasing number of owners of similar quality malls move to that leasing model, it's very, very difficult for other mall owners to resist the direction of travel," he said. "You can push water up a hill for only so long."
What's in store?
The long-term outlook for the retail sector suggests that turnover rents are unlikely to be a temporary fix for struggling retailers and their landlords, Duncan added. "The question is, do you think the power of the internet is going to go down or go up?" he said.
National e-commerce penetration in 2020 is forecast to jump to 26.2% of total retail sales in the U.K., 19.9% in Germany and 14.3% in France due to the impact of the pandemic, and is expected to rise steadily in coming years, according to online data portal Statista.
"If ecommerce penetration is going to rise, then we need to see a reduction in physical retail capacity," said Duncan. "But that doesn't necessarily paint a positive picture for the outlook of the retail space that remains."
Equity investors are unlikely to rediscover their appetite for listed retail landlords so long as the challenges apparent in the wider retail sector, and those posed by turnover rents in particular, remain unresolved, said Duncan. "If growth is so long-dated, the equity investment market doesn't have the timeframes to see through the volatility," he said. "They don't need to sit in a car for five hours if they can take a plane later."
Still, the current lack of support from the equity market may just give listed retail landlords the push they need to address their alarming recent slide, according to Lauder. "The heavy levels of discounting that the likes of a Hammerson or a Shaftesbury PLC or a Landsec or a British Land Co. PLC are trading at currently gives them a considerable window of opportunity to make difficult decisions."
As for Unibail and Klepierre's defiant last stand against the march of turnover rents, Duncan understands their resistance to the model. Describing it as a messy situation, he said: "It's going to take a long time for this to settle down."