How COVID-19 will change retail leasing – during and after the pandemic

07 Apr 2021 07:54 PM

This week, we sat down with Kyle Swain, Retail Director for Lpc Cresa Australia and New Zealand to discuss retail leasing during covid-19 and looking forward into the post pandemic period.  With Brisbane in a 3-day lockdown as this goes to print, the information Kyle provides holds even greater significance and is a timely reminder that tenants need to explore every opportunity to realign lease terms to ensure commercial viability through these extremely uncertain times.
   

What options do retailers have if they agreed on a rental deferral during the early stages of Covid, however their sales have not returned to previous levels and they find themselves paying both their current rent and deferred rent?

There would be many retailers in this exact situation, and we were forewarning this in April last year - “Deferred rent equals deferred pain”, and we never expected retail sales to return to pre-covid levels immediately. I should preface this that by recognising that some categories of retail such as home improvement, outdoor living etc have performed very well during the pandemic, however restaurants, particularly in CBD environments, health clubs, travel retail, and event-based speciality retail like fashion for parties, race days, weddings etc have continued to be significantly impacted.

For businesses that find themselves struggling, like any time during their lease, they need to have an honest conversation with their landlord to discuss available options. That could include a longer period to repay the deferred rent for businesses which will still be viable into the future or negotiating terms to surrender the lease and vacate the shop early. Unfortunately, we see a huge risk period with JobKeeper ending, and believe many businesses will enter into voluntary administration during the June quarter.

What is a sustainable percentage of occupancy costs in relation to turn over, and how has this percentage been trending?

It does vary across categories, and this is particularly impacted by gross margin percentages for different categories.  As a rule of thumb if you wanted one figure to cover all of retail, you would say a sustainable rental is 10-12% of total gross turnover although the lower the better of course and many established retailer brands target 6-8% occupancy costs for their portfolios. For clarity, ‘occupancy costs’ for this calculation include rent, outgoings and any promotional levy charged by the landlord.

Our first piece of advice to achieve a ‘tenant friendly’ Occupancy Cost Ratio (OCR), is to never pay the “recommended retail price” - it’s essential to start with what YOU (the tenant), can afford, not what the landlord wants someone to pay. You should look at your projected turnover from the proposed location.  For example, if you are setting up a new shop and expect to generate $1 million in revenue, then occupancy costs of less than $100,000 is ideal, and any more than $120,000 should be rejected.  If the ‘Recommended Retail Price is above that, make a counter-offer!  If its accepted, all good.  If its rejected, then move on to find a different shop your business can afford to do business in.

As for how its been trending, many of the larger shopping centre landlords feel completely comfortable doing a leasing deal at 20% of forecast turnover or renewing leases at above 20% OCR even when they have sales data from the past year of trade.  LPC Cresa would classify a business operating at 17% to 18% as being in ‘financial distress’. When a business is paying above 17%, they have to look at cost saving measures in other areas, and inevitably this comes from variable costs such as wages or marketing, and an owner may be required to start working in the business more themselves. This creates a downwards spiral in performance of the business which is difficult to recover from.

What nuances are involved with retail leases and how can they differ from other sectors?

A retail lease is generally similar to a standard commercial lease, but typically subject to additional legislative provisions. While each state has different legislation, these provisions have been put in place to offer additional protection to tenants. For example, in some states, retailers who hold less than five leases are considered ‘unsophisticated lessees’ and are required to provide a certificate from a lawyer to demonstrate they’ve received legal advice and another from an accountant to prove they’ve received financial. In New South Wales, Queensland, and Victoria, if a tenant has a market rent review for an option period, they are able to request the landlord’s proposed market rent prior to exercising the option under the ‘early determination of market rent’ provisions which provide enormous benefit to the tenant in the market rent negotiations but the opportunity is largely missed by tenants. 

How do you build flexibility and a safety net into leases in a market where there is genuine concern that we may be subject to further lockdowns throughout 2021?

Where possible, retailers should try and forecast their turnover to include potential impacts that lockdowns may have, thereby influencing a sustainable rent they are prepared to offer.

Essentially, without legislated support, we need to build in a ‘covid factor’ by reducing the proposed forecast turnover – say the pre covid turnover levels – by a reasonable percentage to allow for future impacts from possible lockdowns, restricted travel, ongoing social distancing etc.  The forecast turnover in the post covid-19 era, at least 2021 and 2022 should build in at least 5-10% possible pandemic impact and any landlord negotiations should be based on that figure.

In the early stages of lockdown, discussion in the retail industry was for future leases to contain a ‘force majeure’ or pandemic clause detailing what should happen if tenants and customers are unable to access or trade from the tenancy. The unfortunate fact is that many landlords have just not entertained including them at all, and this status quo is unlikely to change unless tenants start being prepared to walk away from sites en masse if they can’t achieve acceptable terms. 

Broadly speaking, has there been increases or decreases to incentives and rents?

Large format retail businesses are currently experiencing a landlord’s market, with rents at a premium and minimal or no incentives being offered. On the other hand, other categories have seen slight reductions to rents and increases to incentives. Overall, landlords prefer to offer increased incentives rather than lower rents, as rent reductions will have longer lasting impacts on the landlord due to potential impacts on the asset’s valuation or by establishing precedent for lower market rent which will be used in negotiations by other tenants.  Incentives however are recorded in separate deeds and don’t impact the asset’s value in that way whilst providing an artificial means for reducing costs to tenants.

If retailers are looking to open a new store right now, we would suggest waiting until closer to the end of the financial year to assess the impact on market rents as vacancy rates rise once JobKeeper ends and more businesses shutter. 

What innovative ways have you seen retailers pivot as a result of Covid?

There have been some wonderful examples from business operators determined to remain viable.  Some examples I’ve personally witnessed include our local coffee shop refurbishing and reorienting their tenancy to offer serving through their front window, now the pickup window, so the business is Covid safe and can operate even in lockdown conditions, to clients such as Baskin Robbins who rapidly responded to provide home delivery. Within weeks of Covid hitting, Baskin Robbins had full home delivery, to the point where it now makes up approximately 35% of their national sales. It has been extremely positive to see actions which have helped both to save businesses, and to potentially grow turnover.
 

How can Lpc Cresa help?

At Lpc Cresa, we help tenants across Australia and New Zealand with their commercial real estate needs, including transaction advisory, portfolio management and project management.  In summary, we make sure tenant interests are protected and that our clients enter into tenant friendly lease agreements.  
 

Let us help you.