Lease on life - the issue of retail rent

09 August 2018

Mark Schiavello , National Leader, Retail
Partner, Corporate Finance

The majority of retailers I speak with suggest they have their backs to the wall when it comes to high commercial rents, with many considering relocations or closures within their respective store portfolios.

This insight was a little surprising. One would think that commercial landlords of retail spaces across Australia are facing a new reality as merchants cut back on brick and mortar locations and shopping shifts towards online. My view was that property owners would be bending to demands such as rent reductions or short term leases as vacancies soar and retail occupancy continues to plunge. How wrong was I?

According to commercial real estate analysts, rents are on the rise. A Colliers International report into the retail leasing sector revealed that in the second half of 2017, average gross rents in CBD areas increased by ~25% over the past year.

Depending on your situation, there is strong merit in seeking an early negotiation with your landlord.

A growing number of retailers are leveraging lease consulting firms to agree to more favourable terms. Sales trends and margins are not as predictable as they once were, which puts more pressure on aligning occupancy costs with store performance. Like any negotiation it is all about leverage. This will be a case by case scenario.

When a tenant is a highly leveraged retailer that is facing pressure from creditors to restructure or terminate leases outright, landlords are likely to make a deal. As a practical example, Oroton’s landlords decided that reducing rent was safer than the risk of finding a new tenant to occupy almost 60 stores.

If you have a national footprint, negotiate on a portfolio basis rather than on a store by store basis. Landlords won’t agree to a rent reduction just because they like you. You will need to provide a compelling story that articulates how a rent reduction will benefit you and ultimately, them.

Sometimes retailers will be at the mercy of landlords. Research indicates that rents are rising in highly populated metropolitan areas where landlords are sprucing up properties. Without a portfolio approach your ability to renegotiate a lease within a major shopping centre will be limited. SumoSalad’s co-founder and chief executive Luke Baylis said it had tried unsuccessfully for about six months to get a significant rent cut or to walk away from its leases without paying "millions and millions" in outstanding rent. Still, the last thing both sides want to see is a default. So don’t be afraid to hit the negotiating table. But be prepared.

New Accounting Standard impacting leases

The new AASB/IFRS 16 Leases will fundamentally change the accounting for lease transactions in the financial statements of lessees. Given the significant use of rented premises for stores, it is likely to have major implications for the Retail industry.

IFRS 16 will impact almost all retail leases as a right-of-use asset and a corresponding lease liability will be recognised on the statement of financial position of retailers. This will negatively impact net current assets, which is often a key criterion in bank covenants.

The following are the most likely impacts of IFRS 16 on retailers:

  • A larger interest expense being taken through the statement of profit or loss at the start of the lease period, resulting in decreased profit
  • A reduction in the lease liability recognised would not match the depreciation profile of the right-of-use asset, which would lead to a decrease in net assets
  • A portion of the lease liability will be classified as current, resulting in a reduction of net current assets
  • *The cash flow nature of lease payment changes from operating to financing (amounts paid that are attributed to interest are a policy choice).
  • Decrease in net asset which will potentially impact the entity’s ability to declare dividends
  • Deterioration in the debt/equity ratio, due to the increase in liabilities
  • Deterioration in the interest cover ratio, due to the increase in the interest expense

Retailers need to assess the impact on their balance sheets on the date of application of IFRS 16.