How covid-19 affected lease terms in the retail sector

Answer

The high street was teetering on a cliff edge even before March 2020, with a shift in consumer habits resulting in less footfall in town centres and more purchases via the Internet. Since the start of the pandemic, the retail sector has been frozen three times by government-imposed lockdowns leaving businesses more unstable and unprofitable than they could have ever anticipated as well as hesitant looking towards the future.

Tenants and landlords alike have been eager to protect their respective business interests and, as a result, the symbiotic relationship between them has been put under immense strain while conversely becoming more important than ever. 

Adapting the commercial terms of leases which were negotiated in a very different context has become critical and commonplace and I will discuss the trends being seen within the sector which seek to bring corporate occupier leases in line with the changing retail landscape.

Rent concessions

Perhaps the most obvious and desirable adjustment for business tenants is a reduction in rent owing to the fact that, for a proportion of the past year, many retailers have had to close their doors to shoppers which has in turn led to reduced turnover. 

Tenants have sought to cut down outgoings as far as possible, not to seek to increase profit as may have been the case previously but rather to keep from collapse. Contrast this with a landlord who relies on their income from a property portfolio and often has their own obligations to funders which they must meet; allowing a reduced rent has significant negative implications for them. 

Nevertheless, landlords must consider the potential result of pushing a tenant, who perhaps does not have the cash flow to make payments, to breaking point – an insolvent tenant does not make for a profitable landlord. Combined with the fact that few retailers are looking to expand and open new branches, landlords must act carefully to keep units occupied. A vacant unit with no demand for tenants means no income. 

The compromise? Parties are negotiating rent concessions for any period where a tenant is unable to trade from their premises. More emphasis has been placed on careful and precise drafting in the past year to ensure all parties’ interests are adequately protected by the terms of any lease provisions. With contracting parties seeking to find ambiguities and ‘get out’ clauses in their leases, clear definitions of what may amount to ‘unable to trade’ in the context of a rent concession is critical. 

Legislative context

When the first government-imposed lockdown in March 2020 forced the closure of all non-essential shops, the Coronavirus Act 2020 was brought into force, supplemented by the Health Protection (Coronavirus, Business Closure) (England) Regulations 2020. Since then, a number of statutory instruments have introduced the various restrictions that have governed our daily lives. The Health Protection (Coronavirus, Restrictions) (England) (No. 3) Regulations 2020, which are currently in force at the time of writing, allow local authorities to impose restrictions relating to the closure, restricted entry and location of persons within a premises. 

The introduction of new regulations means reference to specific legislation in a lease will not provide for the longevity required. 

A landlord will likely be reluctant to allow a tenant to benefit from any concession when they are legally allowed to operate business. An approach proposed by many is a ‘Rent Concession Period’, defined with reference to a period in which a regulatory body passes an Act of Parliament or statutory instrument to prevent the spread of covid-19 and which makes the tenant operating from the premises unlawful.

However, many in the hospitality industry may find opening when allowed by the government not to be financially viable. Imagine a café with capacity for 30 indoor tables and three outdoor tables. In the period from 12 April 2021, when the café would be legally allowed to serve food and drink outdoors, the overheads of doing so are unlikely to be covered by the turnover in this period. We have seen a similar trend in the retail sector, with businesses keeping select stores closed and the employees on furlough in order to reduce outgoings even when lockdowns have eased, and rules allow for safe opening. 

A compromise satisfactory to a tenant may be the addition of wording to trigger the concession where operating would be unlawful or have a material adverse impact on the business. While protecting the tenant, the landlord can also be comforted by the fact the tenant is prevented from using a rental concession as a way of resting on their laurels.

Alternatively, parties may agree to include a turnover rent clause, which provides for a base rent payable as well as an additional sum calculated based on the turnover a tenant is making. Another option is a stepped rent recovery clause, whereby the rent would be deferred with a tenant paying progressively more as it begins to recover and has a healthier cashflow. The options available to the parties will depend on the bargaining position of both parties as well as the covenant strength of a tenant and its ability to prove a strong enough recovery for deferred payments in the future. 

Day-to-day obligations

While potentially the priority for a business tenant seeking to weather the storm, payment of rent isn’t the only provision of a lease which must be kept under careful consideration when covid-19 regulations restrict how a business can operate. On a practical level, day-to-day obligations of a tenant in a lease to, for example, repair, keep the premises decorated and insure to name but a few become much harder when the premises are not in regular use. This could result in breaches of the lease and entitle a landlord to remedies. 

While a landlord will be reluctant to go as far as allowing a premises to fall into a state of disrepair, an acceptable amendment may be confirmation that tenants will not be in breach of these operational covenants during any ‘lockdown period’, carefully defined as discussed above. The obligations can then resume once the period has ended and access to the premises is more readily available. 

For landlords who may be reluctant to concede that their tenants are not in breach of covenants, the converse approach may be for wording to be added to the extent that a landlord will not be able to make a claim for breach of covenant during a lockdown period.

Break clauses and side letters

It is clear that businesses will be unable to look to the future and accurately predict profit for some time. As well as the threat of new variants causing further local or national lockdowns, it is yet unclear how consumers will choose to shop going forward and whether the move to online shopping during the pandemic represents an irreversible shift.

Moving forward, we are seeing tenants prioritising flexibility through shorter lease terms as well as break options to terminate a tenancy should a store become an unprofitable burden. Of course, this is at odds with the certainty a landlord would desire, but the parties will seek to find a middle ground, such as by way of a slightly longer lease term but with a flexible break. 

Amendments to leases, such as those discussed, are commonly made by a deed of variation or a side letter to the lease. Particular care must be taken when drafting side letters and the effect this may have when a party wishes to exercise their right to break the term and end the tenancy. Break clauses often have conditions attached to them, commonly that all rents outstanding must be paid by the break date for the break to be effective. It is critical that express reference is made to the break clause in any rent concession paragraph of a side letter to ensure the rent as due under any condition of a break is the reduced sum agreed between the parties. In the absence of such provision, a landlord may seek to require the tenant to pay all sums, causing a cashflow problem, as well as undermining the purpose of the rent concession in the first place. 

In short, careful drafting of leases, deeds of variation and side letters is crucial to protect the interests of both parties and prevent a party using vague drafting to demand performance by the other which were not envisioned or intended.

Looking to the future

While the outlook for the coming months is far less bleak than it has been since covid-19 first took hold in the UK in March 2020, businesses are understandably likely to look to the future with some trepidation, and we can expect the negotiation of commercial tenancies to reflect this.

Inevitably there will be a push for shorter lease terms by tenants; the certainty they had once craved is now secondary to the need to adapt to evolving consumer trends in order to future-proof their business. Paired with this, we will likely see more consideration given to break clauses and the conditions attached to them as a mechanism for seeking to react to consumer demand. 

One trend that will likely represent a permanent shift in lease terms is the inclusion of caveats to account for future pandemics. Despite being the first pandemic we have seen (in the author’s lifetime at least), covid-19 has illustrated that the context in which the retail sector operated was not prepared for such change and upheaval. As with the introduction of ‘terrorism’ in insurance provisions in leases following the events of 9/11, we are likely to see pandemic carve outs in a variety of legal contracts going forward, to give piece of mind to any contracting party that in the event of any resurgence or similar outbreak, they are able to easily take steps to keep business afloat. 

While corporate occupiers must keep abreast of the ever-changing social and economic landscape within which they operate, landlords must similarly remain responsive to the needs of their tenants in order to maintain a balance between the parties and ensure profitable arrangements for both in the future.

Abigail Wood is a trainee solicitor at Shoosmiths.